[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]






                    THE TAX CODE AND THE NEW ECONOMY

=======================================================================

                                HEARING

                               before the

                       SUBCOMMITTEE ON OVERSIGHT

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED SIXTH CONGRESS

                             SECOND SESSION

                               __________

                       SEPTEMBER 26 AND 28, 2000

                               __________

                             Serial 106-79

                               __________

         Printed for the use of the Committee on Ways and Means



                    U.S. GOVERNMENT PRINTING OFFICE
68-411 CC                   WASHINGTON : 2001

_______________________________________________________________________
            For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 
                                 20402




                      COMMITTEE ON WAYS AND MEANS

                      BILL ARCHER, Texas, Chairman

PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
BILL THOMAS, California              FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida           ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut        WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York               SANDER M. LEVIN, Michigan
WALLY HERGER, California             BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana               JIM McDERMOTT, Washington
DAVE CAMP, Michigan                  GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington            WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia                 JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio                    XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania      KAREN L. THURMAN, Florida
WES WATKINS, Oklahoma                LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida

                     A.L. Singleton, Chief of Staff

                  Janice Mays, Minority Chief Counsel

                                 ______

                       Subcommittee on Oversight

                    AMO HOUGHTON, New York, Chairman

ROB PORTMAN, Ohio                    WILLIAM J. COYNE, Pennsylvania
JENNIFER DUNN, Washington            MICHAEL R. McNULTY, New York
WES WATKINS, Oklahoma                JIM McDERMOTT, Washington
JERRY WELLER, Illinois               JOHN LEWIS, Georgia
KENNY HULSHOF, Missouri              RICHARD E. NEAL, Massachusetts
J.D. HAYWORTH, Arizona
SCOTT McINNIS, Colorado


Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.




                            C O N T E N T S

                               __________

                                                                   Page

Advisories of September 26 and 28, 2000, announcing the hearing..     2

                               WITNESSES

U.S. Department of the Treasury, Joseph M. Mikrut, Tax 
  Legislative Counsel............................................     9

                                 ______

American Airlines, Inc., Mitchell Salamon........................    81
American Electronics Association, and Transcrypt International, 
  Inc., Michael E. Jalbert.......................................    24
Click Bond, Inc., Collie Langworthy Hutter.......................   109
Edison Electric Institute, and DTE Energy Company, Theodore Vogel    51
Electronic Data Systems Corporation, R. Randall Capps............   100
Hester, J. Joseph, Community College of Allegheny County.........    74
International Furniture Rental Association, Frederick H. von 
  Unwerth........................................................    59
IBM Corporation, Linda Evans.....................................   105
Minge, Hon. David, a Representative in Congress from the State of 
  Minnesota......................................................     5
National Association of Manufacturers:
    Dorothy B. Coleman...........................................    33
    Collie Langworthy Hutter.....................................   109
R&D Credit Coalition, and Microsoft Corporation, Bill Sample.....    93
Semiconductor Industry Association, and Advanced Micro Devices, 
  Clifford Jernigan..............................................    46
Technology Workforce Coalition, and Prometric, Martin Bean.......    77
Verizon Wireless, and Cellular Telecommunications Industry 
  Association, Molly Feldman.....................................    36

                       SUBMISSIONS FOR THE RECORD

American Textile Manufacturers Institute, statement..............   119
Henry George Foundation of America, Columbia, MD, statement......   122
International Franchise Association, Brendan J. Flanagan, letter.   123
IPC, Association Connecting Electronics Industries, letter and 
  attachment.....................................................   124
Tax Council Policy Institute, and PricewaterhouseCoopers LLP, 
  James R. Shanahan, Jr., joint statement........................   130

 
                    THE TAX CODE AND THE NEW ECONOMY

                              ----------                              


                      TUESDAY, SEPTEMBER 26, 2000

                  House of Representatives,
                       Committee on Ways and Means,
                                 Subcommittee on Oversight,
                                                   Washington, D.C.
    The Subcommittee met, pursuant to notice, at 1:04 p.m., in 
room 1100, Longworth House Office Building, the Hon. Amo 
Houghton (Chairman of the Subcommittee) presiding.

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

                       SUBCOMMITTEE ON OVERSIGHT

                                                CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE

September 14, 2000

No. OV-23

                     Houghton Announces Hearing on

                    the Tax Code and the New Economy

    Congressman Amo Houghton (R-NY), Chairman, Subcommittee on 
Oversight of the Committee on Ways and Means, today announced that the 
Subcommittee will hold a hearing on whether Federal tax laws are 
keeping pace with the ``new economy.'' The hearing will take place on 
Tuesday, September 26, 2000, beginning at 1:00 p.m., in the main 
Committee hearing room, 1100 Longworth House Office Building, and be 
continued on Thursday, September 28, 2000, beginning at 11:00 a.m., in 
the main Committee hearing room.
      
    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. 
Witnesses will include a representative of the U.S. Department of the 
Treasury, tax policy experts, and representatives of various sectors of 
the economy. However, any individual or organization not scheduled for 
an oral appearance may submit a written statement for consideration by 
the Committee and for inclusion in the printed record of the hearing.
      

BACKGROUND:

      
    With the emergence of information-based sectors in the economy, 
many observers believe current tax laws improperly measure business 
income. The ``new economy'' is based on high-tech equipment, intensive 
research and development, and a skilled workforce. Many current tax 
rules were written for a predominantly manufacturing economy and may 
need to be revised.
      
    The hearing will review the cost recovery rules for physical 
capital, which are based on analyses from the 1970s and earlier, and 
will receive testimony on the recent Treasury Department Report to the 
Congress on Depreciation Recovery Periods and Methods. The hearing will 
also review the tax treatment of research and development expenses. 
Finally, the hearing will explore how tax law treats the cost of 
maintaining a skilled workforce.
      
    In announcing the hearing, Chairman Houghton stated: ``The strength 
of the economy may be masking underlying inadequacies in our tax laws. 
Rather than waiting for an economic downturn to look at the current 
rules, we want to take advantage of the opportunity to ask whether our 
tax laws make sense. In an increasingly global economy, it is important 
to look at whether our tax rules put us at any competitive 
disadvantage.''
      

FOCUS OF THE HEARING:

      
    The hearing will focus on the tax treatment of physical capital, 
such as equipment; intangible capital, such as research and 
development, and human capital.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Any person or organization wishing to submit a written statement 
for the printed record of the hearing should submit six (6) single-
spaced copies of their statement, along with an IBM compatible 3.5-inch 
diskette in WordPerfect or MS Word format, with their name, address, 
and hearing date noted on a label, by the close of business, Thursday, 
October 12, 2000, to A.L. Singleton, Chief of Staff, Committee on Ways 
and Means, U.S. House of Representatives, 1102 Longworth House Office 
Building, Washington, D.C. 20515. If those filing written statements 
wish to have their statements distributed to the press and interested 
public at the hearing, they may deliver 200 additional copies for this 
purpose to the Subcommittee on Oversight office, room 1136 Longworth 
House Office Building, by close of business the day before the hearing.
      

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be submitted on an IBM compatible 3.5-inch diskette in WordPerfect or 
MS Word format, typed in single space and may not exceed a total of 10 
pages including attachments. Witnesses are advised that the Committee 
will rely on electronic submissions for printing the official hearing 
record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
      
    4. A supplemental sheet must accompany each statement listing the 
name, company, address, telephone and fax numbers where the witness or 
the designated representative may be reached. This supplemental sheet 
will not be included in the printed record.
      
    The above restrictions and limitations apply only to material being 
submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press, 
and the public during the course of a public hearing may be submitted 
in other forms.
      

    Note: All Committee advisories and news releases are available on 
the World Wide Web at ``http://waysandmeans.house.gov.''
      

    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.
      

                                


    Chairman Houghton. Ladies and gentlemen, the hearing will 
come to order. As most of you know, the American economy is on 
a roll, and its success has reached out to many sections of 
this country, and much of the strength is attributed to the so-
called new economy. Much of the new economy, of course, is 
built on information and technology and relies on a highly 
skilled workforce.
    Of course, the Nation's economy is made up of more than 
high technology. There is still an important role for 
manufacturing and trade. But much of the growth in our economy 
is in information, in the high-tech sector. Many of our tax 
rules predate the new economy. For instance, the cost recovery 
rules for capital are based on analyses from the 1970s and 
earlier.
    Why not leave well enough alone, you might ask? The economy 
is strong, but the strength of the economy may be masking 
underlying inadequacies in our tax laws. We shouldn't wait for 
an economic downturn to take a look at the current laws and the 
current rules.
    The new economy uses high-tech equipment, so we need to 
look at the cost recovery rules for physical capital. It relies 
on research and development, so also, we need to take a look at 
the tax treatment of intangible capital. Also, it is driven by 
a skilled workforce, so we need to look at how our tax laws 
treat investment in human capital.
    The Treasury Department is going to be reviewing its recent 
report to the Congress on depreciation periods and methods this 
afternoon, and we will hear from a number of private sector 
witnesses on cost recovery. On Thursday, we will hear from 
witnesses on how our tax laws treat research and development 
and the cost of maintaining a skilled workforce.
    Chairman Houghton. I am now pleased to recognize the senior 
Democrat on our committee, Mr. Coyne, for an opening statement.
    Mr. Coyne. Thank you, Mr. Chairman. As the Chairman pointed 
out, the Oversight Subcommittee has scheduled two days of 
hearings on the tax code and the new economy. It is clear that 
the nature of work has changed in many parts of the U.S. 
economy. As smokestack industries have been overtaken by 
information-based industries, education has become much more 
important to success in our workplaces. Unfortunately, much of 
our workforce is not experiencing the economic benefits of or 
participating in the current economic boom.
    There is, to a large degree, a disconnect between the 
skills the business community needs in the workplaces of the 
future and the skills many hard-working Americans are trained 
to provide. The relationship between the tax laws and the 
ability of this country to maintain a skilled workforce is a 
timely issue for discussion. All one has to do is look at the 
classified employment section of the newspaper to see that the 
vast number of workers sought and the technical skills needed 
for their jobs.
    News reports indicate that currently, there are about 
300,000 high-tech job vacancies. Importantly, the number of 
high-skilled jobs is increasing at an annual rate of 10 
percent, and it is unclear whether these positions can be 
filled. We must focus on what can be done in the short and long 
term to prepare future generations for our, quote, new economy. 
Education and job skills training are critical components of 
efforts to succeed. The tax laws are one important and 
successful tool for encouraging business innovation and job 
training in today's new economic environment.
    I welcome all the witnesses that appear before us today and 
particularly our colleague, Representative Minge.
    Chairman Houghton. Thanks very much, Mr. Coyne.
    Mr. Weller, would you like to make an opening statement?
    Mr. Weller. Yes; thank you, Mr. Chairman. I would like just 
to make a few brief comments. I want to commend you for 
conducting these hearings. You know, today, there is over 100 
million Americans that are online. In fact, seven Americans go 
online for the first time every second. 4.8 million Americans 
today are employed in the technology sector, and that is more 
than oil, steel and auto industries combined. So there is a 
tremendous amount of opportunity.
    And, of course, my home State of Illinois ranking fourth in 
technology employment, third in technology exports, has seen 
wages in the technology sector 59 percent higher than the 
traditional old economy. So we know there is a lot of 
opportunity for Illinoisans as well as all Americans in the 
technology sector to become part of the new economy. But I 
think it is important to note that the tax code does have an 
impact on the new economy, and that is why today's hearing is 
so important. I am proud the House has led the way to, of 
course, lower the tax burden on technology; working to repeal 
the telecommunications tax on telephone service; to extend for 
5 years the Internet tax moratorium and also to move forward 
with legislation to block the FCC from imposing new Internet 
access fees.
    Today's hearing, of course, is on depreciation treatment of 
technology, and I think this is an important subject today and 
one I look forward to engaging with your witnesses in, Mr. 
Chairman. I would like to note that I have introduced 
legislation along with Tom Davis, Billy Tauzin and Jennifer 
Dunn, legislation that addresses the depreciation treatment of 
computers.
    You know, today, our tax code says that you have to keep 
that office computer on the books for 5 years, but the business 
community, you know, which uses computers, whether it is a real 
estate office or a local insurance office as well as a major 
corporation, they replace them about every 14 months. And, of 
course, that just doesn't make sense to carry it on the books 
for 5 years if you are only going to use it in the office for 
barely a year, and our legislation recognizes that; works to 
bring reality, we believe, to the tax treatment for 
depreciation for those office computers, because we would allow 
you to expense or fully deduct in the year that you purchase 
it, the cost of that computer.
    We believe that is common sense, and Mr. Chairman, I would 
like to work with you as well as the Administration, Treasury 
and others to move forward on depreciation reform on the 
treatment of computers and other areas of technology.
    So I look forward to this hearing, and I thank you for the 
opportunity to be part of it.
    Chairman Houghton. Thank you very much.
    Now, we have many distinguished witnesses, none more so 
than the Honorable David Minge, Member of Congress from 
Minnesota.
    Mr. Minge?

  STATEMENT OF HON. DAVID MINGE, A REPRESENTATIVE IN CONGRESS 
                  FROM THE STATE OF MINNESOTA

    Mr. Minge. Well, thank you very much, Mr. Chairman.
    I would like to testify for a couple of minutes about the 
Distorting Subsidies Limitation Act. This is H.R. 1060. It is a 
bill that I have introduced earlier in this session, and I have 
talked to you and a number of our colleagues about one of the 
problems that we face in our economy in trying to ensure that 
we allocate resources in the most logical fashion possible is 
the distortions that occur when the tax code allows and States, 
and local units of government take advantage of, one another.
    And I have a prepared statement that I have filed with the 
committee, and I would like to ask that that be allowed to be 
in the record, and I will make some brief oral comments about 
this and not stick to that statement.
    Chairman Houghton. Absolutely; without objection.
    Mr. Minge. Okay; the problem that I have identified and I 
have worked with several economists on is the efforts that 
States and local units of government make to attract business 
from their neighbors. And we're all familiar with the practice. 
I worked on economic development in the small rural community 
in which I practiced law before I ran for Congress, and I know 
that it was a regular issue: how does Minnesota prevent South 
Dakota from, so to speak, stealing some of its best employers?
    And on the other hand, Minnesota is looking at Connecticut 
or California and asking how can we lure those businesses to 
Minnesota? What incentives do we have to give? Now, the best 
type of competition between the States is to have quality 
education systems; to have infrastructure that meets the needs 
of the business community; to have tax policies which stimulate 
investment. We don't need to be taking billions of dollars of 
taxpayer money and providing direct incentives in the form of 
buildings or sometimes even cash transfers in order to induce a 
business to move from one community to another.
    But, in fact, we are. It has been estimated by Professor 
Kenneth Thomas of the University of Missouri that more than $15 
billion annually of tax money is being spent by State and local 
government to induce businesses to move from one location to 
another. This is a vast sum. It would educate 3 million 
elementary school students for a year; it would hire 300,000 
law enforcement officers or construct 6,000 miles of four-lane 
highway.
    We can't afford as a country to watch this amount of money 
being spent unnecessarily and in a way that doesn't make sense 
with sound economic policy. This is a situation that cries out 
for a response, and indeed, we have been requested by several 
State legislators; many economic planners, governors and others 
to take action, because what the States have found is that they 
can't unilaterally disarm. One State, let's say New York, can't 
say we are not going to offer any subsidies to try to prevent 
businesses from leaving New York; we will simply have the best 
environment possible for businesses in our State.
    But then, New Jersey comes along, and it says wouldn't you 
like to move the New York Stock Exchange over to Hoboken? Or 
wouldn't you like to have your corporate headquarters over in 
Jersey City or some other location, or Kvaerner is in 
Pennsylvania, and the ship yards in Philadelphia are to be 
reconstructed, and I believe there was a $400 million package 
that was offered to Kvaerner.
    If New York tries to disarm and not use that, but New 
Jersey does not, then, the businesses will exploit this 
difference. And so, what has been pointed out is that it takes 
Congressional action if we are going to deal with this 
situation, and this, in a sense, is an unfinished item of 
business from the establishment of our Federal union. It was 
not adequately dealt with initially by Congress, and it has 
lingered, and it has festered.
    In my own home State, we have been treated to the spectacle 
of professional sports teams imploring the State legislature 
and the governor for untold millions of dollars for new 
stadiums. Otherwise, the sports team says we have no 
alternative but to go to another State which will offer us a 
stadium that they have paid for.
    Well, this is just one aspect of a problem that I think is 
severe, and with a $15 billion a year price tag, it is very 
costly to State and local government. The legislation that I 
have introduced would address this by first having an excise 
tax on the benefits, so that there would be a negative 
incentive for businesses to seek this type of assistance. It 
would also preclude the use of Federal grant money for that 
type of subsidy; and finally, it would make sure that 
industrial revenue bonds or enterprise bonds cannot be issued 
and have their interest treated as tax free under the Internal 
Revenue Code if the proceeds are to be used in this manner.
    I must say that I have worked very closely with several 
economists on this. The Federal Reserve Bank of Minneapolis has 
made this a top priority in terms of economic research and 
policy development at that bank, and the chief economist at the 
bank has assisted in the preparation of this legislation.
    One final comment in this respect: I have held roundtable 
discussions with folks on this proposal, and the comment that 
came from a businessperson was the biggest problem with your 
bill is that the excise tax is not high enough. It ought to be 
100 percent. And instead, the tax rate that was chosen is the 
corporate tax rate under the Internal Revenue Code.
    Well, I would like to thank you very much for the 
opportunity to testify about this problem. I think it is 
certainly one that our States face as they compete with one 
another for high-tech industry, in this new-age economy, and 
hopefully, it is something that we can address as we attempt to 
address other problems that face our country and face our 
economy. Thank you very much.
    [The prepared statement follows:]

Statement of Hon. David Minge, a Representative in Congress from the 
State of Minnesota

    I am pleased by the opportunity to testify before the 
subcommittee today on an abuse of the tax code that unwillingly 
facilitates the tragic bidding war among communities for 
business development. This handicaps our communities from 
making adequate investments to prepare them and their citizens 
for the economic demands of the new millennium.
    States and cities across the country are competing against 
one another to lure companies that will provide jobs to local 
residents. This has been happening for years, and it probably 
always will, given our country's commitment to the free market 
economy and rigorous competition. Some localities simply do a 
better job of ensuring that their area has an educated 
workforce, efficient transportation infrastructure, and is 
generally more attractive to employers. That's one of the 
tenets of good government--create an environment that promotes 
economic growth and jobs.
    We all support such competition. But in the last several 
years we have seen an increase in competition between the 
States based on something other than the quality of the 
infrastructure, schools, or available labor force. Local 
governments are being forced to spend scarce taxpayer dollars 
for incentives to attract specific companies looking for a new 
home, or even more discouraging, just to keep a business from 
packing up and leaving town.
    The problem begins with our tax code. The Federal 
Government has attempted to address this situation in the past 
by tackling the most offensive abuses. Limits were placed on 
the use of tax free municipal bonds to finance projects that 
benefit a specific business. Despite the existence of these 
limitations, the money generated by ``enterprise'' bonds is 
typically a subsidy for a private entity and not recognized as 
taxable income.
    All told, State and local government across the country 
provide more than $15 billion annually in tax rebates and other 
subsidies, according to Kenneth Thomas of the University of 
Missouri, St.Louis. That price tag is staggering. Those funds 
could educate 3 million elementary school students, hire 
300,000 police officers or construct 6,000 miles of four-lane 
highway.
    It gets worse. Some of these distorting subsidies are 
financed through Federal tax dollars. The U.S. General 
Accounting Office (GAO) reports that Federal block grant funds 
are being used not only to create jobs, but subsidize the 
movement of jobs from one State to another. Why should the 
nation's taxpayers finance these deals that benefit job growth 
of one State to the detriment of another?
    This practice is wide spread. A 1993 Arizona Department of 
Revenue study found that half of the 50 States had recently 
enacted financial incentives to induce companies to locate, 
stay or expand in the State. Targeted businesses have ranged 
from airline maintenance facilities, automobile assembly plants 
and professional sports teams to chopstick factories and corn 
processing facilities. These deals often range into the 
hundreds of millions of dollars.
    For example, Pennsylvania, bidding for a Volkswagen factory 
in 1978, gave a $71 million incentive package for a factory 
that was projected to eventually employ 20,000 workers. The 
factory never employed more than 6,000 and was closed within a 
decade.
    In a 1993 agreement with the State of Alabama, Mercedes 
received a sweetheart subsidy package worth $253 million to 
build an auto plant in that job-starved State. Each of the 
1,500 jobs created cost the State taxpayers $168,000.
    Recently, the Marriott Corporation gleaned what is 
estimated to be as much as $70 million in subsidies from the 
State of Maryland and Montgomery County to expand their 
operation. This firm has been headquartered for decades in the 
Free State, and has prospered nicely with the help of an 
educated and productive workforce. When company executives 
threatened to pick up and leave after 44 years in Maryland, and 
when they sat down with Virginia officials to discuss 
``options,'' Maryland had little choice but pony up with $70 
million in tax breaks and road projects or risk seeing Marriott 
ride into the sunset.
    New York City is in a constant battle with the States of 
Connecticut and New Jersey to retain many businesses currently 
located within its boundaries. The last year has seen millions 
upon millions of dollars showered on such well known financial 
and publishing firms as Bloomberg, Bertelsmanns, Time Warner, 
the New York Stock Exchange, the New York Board of Trade, CBS, 
etc . . . Are these the companies that are truly in the need of 
government subsidies?
    It is appropriate that I sit before the Subcommittee on 
Oversight as oversight of these incentive deals is woefully 
inadequate. According to a report by Good Jobs First, most 
States lack comprehensive incentive strategies and follow up 
audits are rare and of poor quality. Often subsidies are given 
to corporations with poor fiscal histories or are not used in 
the areas or ways originally intended.
    One glaring example is the deal $429 million public subsidy 
of the Norwegian ship builder Kvaerner. The purpose of the 
subsidy was to entice Kvaerner to build a new ship yard at the 
site of the former Philadelphia Naval Shipyard. According to an 
August release from the Pennsylvania Auditor General, subsidy 
money was squandered on items such as a $2,000 swing set, 
basement renovations and other personal items for a Kvaerner 
executive. Kvaerner has since pulled out of the ship building 
industry.
    While spending billions of dollars to retain and attract 
businesses, State and local governments struggle to provide 
such public goods as schools and libraries, public health and 
safety facilities, and the roads, bridges and parks that are 
critical to the success of any community. These subsidy deals 
have a direct effect on the availability and quality of public 
services.
    The city of Cleveland, while it struggled to keep the 
Cleveland Browns football team from moving to Baltimore, 
announced the closing of 11 schools in 1995 for lack of 
funding, yet the city offered to spend $175 million of public 
money to fix the Browns' stadium to ward off Baltimore's 
successful offer to attract the team.
    My own State of Minnesota is experiencing a similar 
dilemma. There has been a lot of talk in the last couple of 
years about the Minnesota Twins being lured away by a publicly 
financed stadium in another part of the country. That talk had 
quieted but has just recently reappeared on the front pages of 
Minnesota newspapers. The Twins have long been pressing the 
State and local government for a new sports stadium. It appears 
now that the cities of Minneapolis and St. Paul are gearing up 
for a bidding war to publicly finance a new stadium to lure the 
team. This comes only a few years after the State legislature 
and the city of Minneapolis decided against financing a 
stadium.
    Individual States and local governments are powerless to 
put a stop to the practice. Unilateral disarmament in this 
bidding war could mean the loss of thousands of jobs to other 
jurisdictions. At the same time, businesses cannot be blamed 
for wanting to move into a community that offers the best 
incentive package. What is clear is that the system itself is 
flawed, and that we are due for a tune up.
    I have had some personal experience with the issue when I 
served on the County Development Commission in my hometown of 
Montevideo in western Minnesota. I know from my own work how 
frustrating it can be for a smaller community to have to 
compete with communities that have deeper pockets or that are 
more willing to give breaks or go into debt to win a deal.
    We must start considering how to stop the use of tax 
subsidies that squander limited public resources and distort 
economic decision-making. I am encouraged that nine State 
governments, including the Minnesota Legislature, have passed 
resolutions urging Congress to find an answer to this lingering 
question. I have consulted with the Minnesota Department of 
Trade and Economic Development, Mel Burstein and Art Rolnick of 
the Minneapolis Federal Reserve Bank, Ohio State Senator 
Charles Horn, local economic development planners and many 
others to develop legislation and build interest in resolving 
this problem.
    I have introduced a bill that is intended to end 
competition based on public giveaways rather than sound 
economic principles. The Distorting Subsidies Limitation Act of 
1999 (HR 1060) requires businesses benefitting from special 
grants or tax deferrals to be taxed on the value of the 
subsidies at the same rates as currently apply to other income 
under the Federal corporate tax structure. Let's face it, these 
subsidies are income that businesses are milking out of local 
government. I think of this proposed tax as a ``sin tax'' meant 
to stop an undesirable activity. I also propose an across the 
board prohibition on the use of tax-exempt bonds or Federal 
resources by States and communities to lure businesses or 
prevent them from considering other locations.
    Several other members of Congress have put together 
legislative proposals in attempt to halt these distorting 
subsidies. I salute their efforts, and hope that as concern 
about this unwise use of public resources continues to grow, we 
in Congress can hammer out a consensus approach. The point is 
that Congress is empowered by the Interstate Commerce Clause as 
the only entity that can put a stop to the economic war between 
the States.
      

                                


    Chairman Houghton. Well, thanks very much, Dave.
    Have you got any questions? No, I don't have any questions? 
Do you, Jerry? Okay; good; thank you so much, and we expect to 
receive your written testimony.
    Mr. Minge. Okay.
    Chairman Houghton. Thanks very much.
    Now, the next witness is Mr. Joseph Mikrut, who is the tax 
legislative counsel for the United States Department of the 
Treasury. Mr. Mikrut, it's good to have you here.
    Mr. MIKRUT. Thank you.
    Chairman Houghton. And whenever you're ready, you can begin 
your testimony.

 STATEMENT OF JOSEPH M. MIKRUT, TAX LEGISLATIVE COUNSEL, U.S. 
                   DEPARTMENT OF THE TREASURY

    Mr. Mikrut. Thank you, Mr. Chairman, Mr. Coyne, 
distinguished members of the Subcommittee.
    I appreciate the opportunity today to discuss with you the 
tax rules that relate to investments in human, intangible and 
physical capital in the context of the new economy. Over the 
last 20 years, the U.S. economy has changed significantly. New 
industries have emerged, and the use of technology has 
revolutionized production techniques and improved the 
efficiency in more traditional industries. These developments 
have increased the demand for more highly skilled workers who 
are more productive and better able to adapt to the 
requirements of new technologies.
    In addition, access to computers and the Internet has 
increased significantly, creating opportunities to participate 
in the new digital economy. In view of these changes, this 
hearing appropriately focuses on whether Federal tax rules are 
keeping pace with the new economy. The Treasury Department has 
previously submitted testimony on the importance of the 
Administration's budget initiatives supporting the research 
credit; providing educational incentives; bridging the digital 
divide and making life-saving vaccines available worldwide.
    I will not repeat these discussions this afternoon. Rather, 
my comments will focus on the results of the Treasury 
Department's recent analysis of current-law cost recovery 
provisions. This last July, the Treasury Department issued its 
report to the Congress on depreciation recovery periods and 
methods. In developing its study, the Treasury Department 
solicited and received comments from numerous interested 
parties and consulted with the tax writing committee staffs.
    The report emphasizes that an analysis of the current U.S. 
depreciation system involves several issues, including those 
related to proper income measurement, savings and investment 
incentives and the administerability of the tax system. The 
history of the U.S. tax depreciation system has shown that 
provisions intended to achieve certain of these goals; for 
example, attempting to measure income accurately by using a 
facts and circumstances approach, may clash with other 
worthwhile goals; for example, having to have a very 
administerable, easy-to-apply system.
    Accordingly, the report identifies issues related to the 
design of a workable and relatively efficient depreciation 
system and reviews options for possible improvements to the 
current system with those competing goals in mind. Resolution 
of the issue of how well the current recovery periods and 
methods reflect the useful lives and economic depreciation 
rates would involve detailed empirical studies and years of 
analysis. The data required for this analysis would be costly 
and difficult to obtain. Thus, the report does not contain any 
legislative recommendations concerning specific recovery 
periods or methods for any particular piece of property. 
Rather, the report is intended to serve as a starting point for 
public discussion of possible general improvements to the U.S. 
cost recovery system. We look forward to working with the tax 
writing committees in this endeavor.
    Based on available estimates of economic depreciation, tax 
depreciation allowances are more generous at current inflation 
rates, on the average, than those implied by economic 
depreciation. This conclusion, however, is based on estimates 
of economic depreciation that may be somewhat dated. The 
relationship between tax and economic depreciation changes with 
the rate of inflation, and because current law depreciation 
allowances are not indexed for inflation, the current low rates 
of inflation reflect the fact that economic depreciation may be 
slower than tax depreciation.
    In general, current law generally generates relatively low 
tax costs for investment in equipment, public utility property 
and intangibles and relatively high tax costs for investments 
in nonresidential buildings. These differences in tax costs, 
standing alone, may distort investment decisions, encouraging 
investors to underinvest in projects with relatively high tax 
costs.
    The report also finds that the current depreciation system 
is dated. The asset class lives that serve as the primary basis 
for the assignment of recovery periods have remained largely 
unchanged since 1981 and are largely based on studies that date 
back to the 1960s. Entirely new industries have developed in 
the interim, and manufacturing processes in traditional 
industries have changed. These developments are not reflected 
in the current cost recovery system, which does not provide for 
updating depreciation rules to reflect new assets, new 
activities and new production technologies.
    As a consequence, income may be mismeasured for these 
assets relative to the measurement of income generated by 
properly classified assets. However, this does not mean that 
depreciation allowances for new assets or new industries are 
necessarily more mismeasured than other assets.
    The replacement of the existing tax depreciation structure 
with a system more closely related to economic depreciation is 
sometimes advocated as an ideal reform. However, there are 
several issues that come about with this reform. One issue is 
trying to find the appropriate data in order to reflect proper 
economic depreciation. A second reform would involve indexing 
for inflation. Current law does not--as I mentioned earlier, 
does not index for inflation, while an ideal income tax system 
would. Indexing, however raises several concerns, including the 
revenue costs, complexity and possible undesirable, tax-
motivated transactions.
    In summary, Mr. Chairman, the Treasury Department's recent 
depreciation report raises several issues that need to be 
addressed in modifying the present cost recovery system and 
provides several possible options for modifications in the 
system. We intend that the report would serve as a starting 
point for public discussion of improvements to the cost 
recovery system. We applaud the efforts of Chairman Archer in 
commissioning this study and you, Mr. Chairman, in holding this 
hearing to further this discussion.
    We look forward to working with you and the tax-writing 
committees on this matter. I'd like to submit my entire 
statement for the record, and I'd be happy to answer any 
questions you may have.
    [The prepared statement follows:]

Statement of Joseph M. Mikrut, Tax Legislative Counsel, U.S. Department 
of the Treasury

    Mr. Chairman, Mr. Coyne, and distinguished Members of the 
Subcommittee:
    Thank you for giving me the opportunity to discuss with you 
today the tax rules governing depreciation, research and 
experimentation, and workforce training in the context of the 
``new economy.'' Over the past 20 years, the U.S. economy has 
changed significantly. New industries have emerged, such as 
cellular communications and the Internet, and the use of 
computers has revolutionized production techniques and improved 
efficiency in more traditional industries, such as 
manufacturing. In many industries these developments have 
increased the demand for more highly-skilled workers who are 
more productive and better able to adapt to the requirements of 
technological advances. In addition, access to computers and 
the Internet has increased significantly, creating 
opportunities to participate in the new digital economy.
    In view of these economic changes, this hearing 
appropriately focuses on whether Federal tax laws are keeping 
pace with the new economy.
    My comments today will focus on the results of the Treasury 
Department's recent analysis of cost recovery provisions in 
Report to the Congress on Depreciation Recovery Periods and 
Methods. I will also review the tax treatment of research and 
experimentation expenses and the tax treatment of the cost of 
maintaining a skilled workforce. The Administration recognizes 
the importance of the research credit for encouraging 
technological development and has supported its extension. The 
Administration's FY 2001 Budget includes proposals that would 
encourage individuals and businesses to undertake more 
education and training. In addition, the Administration 
recognizes the need to ensure that residents of inner cities 
and less affluent rural communities have full access to the 
opportunities that symbolize the promise of the new economy. In 
that regard, the Budget includes several proposals that will 
help bridge the digital divide.

                    The Treasury Depreciation Study

    The Tax and Trade Relief Extension Act of 1998 directed the 
Secretary of the Treasury to conduct a comprehensive study of 
the recovery periods and depreciation methods under section 168 
of the Internal Revenue Code, and to provide recommendations 
for determining those periods and methods in a more rational 
manner. The explanation of the directive in the 1998 Act 
indicates that the Congress was concerned that the present 
depreciation rules may measure income improperly, thereby 
creating competitive disadvantages and an inefficient 
allocation of investment capital. The Congress believed that 
the rules should be examined to determine if improvements could 
be made. In developing its study, the Treasury Department 
solicited and received comments from numerous interested 
parties.
    In July, 2000 the Treasury Department issued its Report to 
the Congress on Depreciation Recovery Periods and Methods. The 
Report emphasizes that an analysis of the current U.S. 
depreciation system involves several issues, including those 
relating to proper income measurement, savings and investment 
incentives, and administrability of the tax system. The history 
of the U.S. tax depreciation system has shown that provisions 
intended to achieve certain of these goals (for example, 
attempting to measure income accurately by basing depreciation 
on facts and circumstances) may come at the cost of other 
worthwhile goals (for example, reducing compliance and raising 
administrative burdens). Accordingly, the Report identifies 
issues relating to the design of a workable and relatively 
efficient depreciation system, and reviews options for possible 
improvements to the current system with these competing goals 
in mind.
    Resolution of the issue of how well the current recovery 
periods and methods reflect useful lives and economic 
depreciation rates would involve detailed empirical studies and 
years of analysis. The data required for this analysis would be 
costly and difficult to obtain. Thus, the Report does not 
contain legislative recommendations concerning specific 
recovery periods or depreciation methods. Rather, the Report is 
intended to serve as a starting point for a public discussion 
of possible general improvements to the U.S. cost recovery 
system. We look forward to working with the tax-writing 
Committees in this important endeavor.

Current Law

    The Internal Revenue Code allows, as a current expense, a 
depreciation deduction that represents a ``reasonable allowance 
for the exhaustion, wear and tear (including a reasonable 
allowance for obsolescence)--(1) of property used in a trade or 
business, or (2) of property held for the production of 
income.'' Since 1981, the depreciation deduction for most 
tangible property has been determined under rules specified in 
section 168 of the Code. The Modified Accelerated Cost Recovery 
System, or MACRS, specified under section 168 applies to most 
new investment in tangible property.
    MACRS tax depreciation allowances are computed by 
determining a recovery period and an applicable recovery method 
for each asset. The recovery period establishes the length of 
time over which capital costs are to be recovered, while the 
recovery method establishes how capital costs are to be 
allocated over that time period. All tax depreciation is based 
on the original, historical cost of the asset and is not 
indexed for inflation.
    The tax code assigns equipment (and certain non-building 
real property) to one of seven recovery periods that range in 
length from three years to 25 years. This assignment typically 
is based on the investment's class life. Class lives for most 
assets are listed in Rev. Proc. 87-56; others are designated by 
statute. Generally, assets with longer class lives are assigned 
longer recovery periods.
    For equipment, the MACRS recovery period depends either on 
the type of asset or the employing industry. Certain assets, 
such as computers, office furniture, and cars and trucks are 
assigned the same recovery period in all industries. To a large 
extent, however, the current depreciation system is industry 
based rather than asset based, so that assets are assigned 
recovery periods determined by the employing industry.
    The applicable method of depreciation depends on the 
asset's recovery period. Assets with a recovery period of 
three, five, seven or ten years generally use the double 
declining balance method. Assets with a fifteen or a twenty-
year recovery period generally use the 150 percent declining 
balance method. Assets with a twenty-five year recovery period 
use the straight-line method.
    Non-residential buildings generally are depreciated over a 
39-year recovery period using the straight-line method. 
Nonresidential buildings include commercial buildings, such as 
office buildings and shopping malls, as well as industrial 
buildings such as factories. Residential buildings (e.g., 
apartment complexes) are depreciated over a 27.5-year period 
using the straight-line method. The recovery period for 
buildings is the same regardless of industry. For tax purposes, 
a building includes all of its structural components. The cost 
of these components is not recovered separately from the 
building; rather these costs are recovered using the life and 
method appropriate for the building as a whole.

Principal Issues and Findings

    Based on available estimates of economic depreciation, cost 
recovery allowances for most assets are more generous at 
current inflation rates, on average, than those implied by 
economic depreciation. This conclusion, however, is based on 
estimates of economic depreciation that may be dated. The 
findings are discussed more fully in the Report. The 
relationship between tax and economic depreciation changes with 
the rate of inflation because current law depreciation 
allowances are not indexed for inflation. Furthermore, the 
relationship between tax depreciation and economic depreciation 
varies substantially among assets. In general, accelerated cost 
recovery allowances generate relatively low tax costs for 
investments in equipment, public utility property and 
intangibles, while decelerated cost recovery allowances 
generate high tax costs for investments in other nonresidential 
buildings. These differences in tax costs, standing alone, may 
distort investment decisions, discouraging investment in 
projects with high-tax costs, even though they may earn higher 
pre-tax returns.
    The current depreciation system is dated. The asset class 
lives that serve as the primary basis for the assignment of 
recovery periods have remained largely unchanged since 1981, 
and most class lives date back at least to 1962. Entirely new 
industries have developed in the interim, and manufacturing 
processes in traditional industries have changed. These 
developments are not reflected in the current cost recovery 
system, which does not provide for updating depreciation rules 
to reflect new assets, new activities, and new production 
technologies. As a consequence, income may be mismeasured for 
these assets, relative to the measurement of the income 
generated by properly classified assets. However, this does not 
mean that depreciation allowances for assets used in newer 
industries or for new types of assets in older industries are 
necessarily more mismeasured than other assets.
    Current class lives have been assigned to property over a 
period of decades, under a number of different depreciation 
regimes serving dissimilar purposes, and with changed 
definitions of class lives. The ambiguous meaning of certain 
current class lives contributes to administrative problems and 
taxpayer controversies. The current system also makes difficult 
the rational inclusion of new assets and activities into the 
system, and inhibits rational changes in class lives for 
existing categories of investments.

Policy Options

    The replacement of the existing tax depreciation structure 
with a system more closely related to economic depreciation is 
sometimes advocated as the ideal reform. While perhaps 
theoretically desirable, such a reform faces serious practical 
problems. An approach based on empirical estimates of economic 
depreciation is hampered by inexact and dated estimates of 
economic depreciation, and by measurement problems that will 
plague new estimates. Economic depreciation also requires 
indexing allowances for inflation. Indexing raises several 
concerns, because it would be complex and may lead to 
undesirable tax shelter activity. Another concern is its 
revenue cost; indexing could be expensive at high inflation 
rates.
    Because of other inefficiencies in the tax code, it is 
unclear that switching to a system based on economic 
depreciation would necessarily improve investment decisions. 
Switching to economic depreciation could exacerbate some tax 
distortions at the same time that it alleviated others. At 
current inflation rates, switching to economic depreciation 
would raise the tax cost of most business investment. Thus, it 
would reduce overall incentives to save and invest. However, 
because current depreciation allowances are not indexed for 
inflation, at higher inflation rates switching to economic 
depreciation would promote both lower and more uniform taxes on 
capital income.
    Comprehensively updating and rationalizing the existing 
asset classification system would address several income 
measurement and administrative problems. For example, it would 
allow the proper classification of new assets and assets that 
have changed significantly. Comprehensive reform of MACRS 
recovery periods and methods would be possible once the class-
life system has been rationalized. These changes might move the 
system closer to one based on economic depreciation, or perhaps 
provide a more uniform investment incentive. A systematic 
overhaul, however, would be an ambitious project. It would 
involve a significant (and costly) effort to collect and 
analyze data in order to determine the class lives of new and 
existing assets and activities. This would place a large burden 
on taxpayers required to provide these data. It also may 
require granting Treasury the resources and the authority to 
change class lives.
    Less comprehensive changes could improve the functioning of 
the current depreciation system. These changes might address 
narrower issues, such as the determination of the appropriate 
recovery period for real estate, the possible recognition of 
losses on the retirement of building components, or the 
reduction of MACRS recovery period cliffs and plateaus. These 
and other issues are discussed in more detail in the Report.
    For many industries, technological obsolescence may be a 
more important factor in determining asset depreciation than 
physical wear and tear. The decline in value of certain assets 
may be associated with the introduction of newer, more 
technologically superior assets that may cause a rapid 
disposition of assets of earlier vintage. Moreover, with 
increased computerization, technological changes may be 
occurring more frequently than in the past. In such 
circumstances the determination of appropriate tax depreciation 
may raise the concern that current recovery periods do not 
adequately reflect the rapid decline in value due to more 
frequent replacement or to other factors. In particular, the 
development of computers and the integration of computers into 
the production process raises the concern that the current 
recovery period is too long for computers and for production 
equipment that increasingly relies on computer technology.
    Current law creates a distinction between stand-alone 
computers and computers used as an integrated part of 
technology. Stand-alone computers are given a five-year 
recovery period. Computers used as an integral part of other 
equipment are depreciated on a composite basis as part of the 
underlying asset. Consequently, their costs generally are 
recovered over 5, 7, 10 or more years.
    Some commentators have suggested that, at least in their 
initial applications, computers do not generally last for five 
years. This suggests rapid obsolescence, which some 
commentators use to support their argument that the five-year 
recovery period for computers is too long. However, the useful 
economic life of a computer does not end with its initial 
application. We are aware of no careful empirical study that 
clearly substantiates the claim that computers have a 
sufficiently short useful economic life to merit a shorter 
recovery period.
    Some industry representatives also argue that computerized 
equipment may be depreciated over too long a recovery period. 
Most class lives for equipment pre-date the computer 
revolution. Thus, the class lives may fail to reflect the 
relatively large cost share currently accounted for by 
relatively short-lived computer components. A possible solution 
to this problem would be to depreciate assets that encompass 
integrated circuits or ``computers'' using the same 5-year 
recovery period available to stand-alone computers. While 
eliminating the tax distinction between integrated and stand-
alone computers has merit, it also raises two serious concerns. 
First, integrated circuits are widely used. Consequently, 
depreciating over the same 5-year period all equipment that 
contains a computer would effectively restore ACRS in that 
virtually all equipment would receive the same (short) 
depreciation write-off. Such a depreciation system would not be 
neutral if, in fact, the equipment has different economic 
lives; it would favor those industries whose equipment lasts 
longer than 5 years. Second, restricting the 5-year recovery 
period to the cost component represented by computer technology 
would raise difficult problems in tax administration. 
Separating the cost of the integrated computer from the cost of 
remainder of the property would be very difficult.
    Another issue arises out of the general difficulty the 
current system has in establishing and modifying class lives. 
Because establishing and changing class lives and recovery 
periods generally requires Congressional action, it has proven 
difficult to keep the tax depreciation system current. One 
possible solution would give Treasury the authority to 
establish and modify class lives. To be effective, Treasury 
also would need the additional authority to require taxpayers 
to collect, maintain, and submit the data necessary to measure 
economic depreciation or useful economic lives. The collection, 
maintenance and provision of these data, however, would impose 
a heavy cost on taxpayers, and the data's analysis would 
require significant Treasury resources. In addition, a 
piecemeal approach to modifying class lives may not improve 
overall neutrality, because depreciation rules would be 
established or modified only for a subset of assets.

             Tax Treatment of Research and Experimentation

    Technological development is an important component of 
economic growth and our ability to compete in the global 
marketplace. However, firms may underinvest in research because 
it is difficult to capture the full benefits from their 
research and to prevent their costly scientific and 
technological advances from being copied by competitors. 
Because other firms and society at large frequently benefit 
from the spillover of research conducted by individual firms, 
the private return to research often is lower than the total 
return. In this situation, government action can improve the 
allocation of resources by increasing research activity.
    The tax rules provide a number of incentives for research 
and experimentation. To encourage taxpayers to undertake 
research, and to simplify the Administration of the tax laws, 
special flexible tax accounting rules are provided for 
investments in the research and experimentation. This treatment 
may be applied to the costs of wages and supplies incurred 
directly by a taxpayer, to contract research expenses for 
research undertaken on behalf of a taxpayer by another, and to 
cost sharing research expenses resulting from technology 
sharing arrangements with related foreign parties.
    Taxpayers may elect to deduct currently the amount of 
research and experimental expenditures incurred in connection 
with a trade or business, notwithstanding the general rule that 
business expenses to develop or create an asset with a useful 
life extending beyond the current year must be capitalized. 
Expensing of research and experimentation expenditures provides 
a tax incentive for such activities and is simple. To encourage 
investments by start-up companies in research, this election to 
deduct research expenses may be applied prior to the time a 
taxpayer becomes actively engaged in a trade or business. Under 
these rules, taxpayers have the option to elect to defer and 
amortize research and experimental expenditures over five 
years, and this election may be applied for all of a taxpayer's 
research expenses or on a project by project basis. Pursuant to 
a long-standing revenue procedure, the tax accounting rules 
applicable to research and experimental expenditures also 
extend to software development costs.
    As a further inducement to the conduct of research, a 
special five-year depreciation life is provided for tangible 
personal property used in connection with research and 
experimentation.
    The research credit fosters new technology by encouraging 
private-sector investment in research that can help improve 
U.S. productivity and economic competitiveness. For that 
reason, the Administration has supported an extension of the 
research credit.
    Under present law, the research credit is equal to 20 
percent of the amount by which a taxpayer's qualified research 
expenditures exceed a base amount. The base amount for the 
taxable year is computed by multiplying a taxpayer's ``fixed-
base percentage'' by the average amount of the taxpayer's gross 
receipts for the four preceding years. Except in the case of 
certain start-up firms, the taxpayer's fixed-base percentage 
generally is the ratio of its total qualified research 
expenditures for 1984 through 1988 to its gross receipts for 
those years. The base amount cannot be less than 50 percent of 
the qualified research expenses for the year.
    Taxpayers are allowed to elect an alternative research 
credit regime. Taxpayers that elect this regime are assigned a 
three-tiered fixed base percentage (that is lower than that 
under the regular research credit) and a lower credit rate. A 
credit rate of 2.65 percent applies to the extent that a 
taxpayer's research expenses exceed a base amount computed 
using a fixed-base percentage of 1 percent but do not exceed a 
base amount computed using a fixed-base percentage of 1.5 
percent. A credit rate of 3.2 percent applies to the extent 
that a taxpayer's research expenses exceed a base amount 
computed using a fixed-base percentage of 1.5 percent but do 
not exceed a base amount computed using a fixed-base percentage 
of 2.0 percent. A credit rate of 3.75 percent applies to the 
extent that a taxpayer's research expenses exceed a base amount 
computed using a fixed-base percentage of 2.0 percent.
    Qualified research expenditures consist of ``in house'' 
expenses of the taxpayer for research wages and supplies used 
in research, and 65 percent of amounts paid by the taxpayer for 
contract research conducted on the taxpayer's behalf (75 
percent for amounts paid to research consortia). Certain types 
of research are specifically excluded, such as research 
conducted outside the United States, research in the social 
sciences, arts, or humanities, and research funded by another 
person or governmental entity.
    A 20-percent research credit also is allowed for corporate 
expenditures for basic research conducted by universities and 
certain nonprofit scientific research organizations to the 
extent that those amounts exceed the greater of two prescribed 
floor amounts plus an amount reflecting any decrease in non-
research donations.
    The deduction for research expenses is reduced by the 
amount of research credit claimed by the taxpayer for the 
taxable year. The credit is scheduled to expire on June 30, 
2004.

      Tax Treatment of the Cost of Maintaining a Skilled Workforce

    The skill of America's labor force is crucial to 
maintaining the U.S. role in the world economy. Well-educated 
workers are essential to an economy experiencing technological 
change and facing global competition. Not only are better-
educated workers more productive, they are more adaptable to 
the changing demands of new technologies. A highly skilled 
labor force makes possible technological change and its spread 
throughout the economy. Current tax law encourages employers to 
invest in worker training and individuals to invest in their 
own skills. Administration proposals would create additional 
incentives.
    Under present law, employers deduct from current income the 
costs of training and educating their workers, whether the 
expenses are paid to third-party providers or to the firms' own 
employees who provide formal or informal training. Education 
and training is deductible either as a necessary business 
expense (section 162) if it is related to the employee's 
current job position, or as employee compensation if it is 
unrelated. Although education and training often contributes to 
a worker's human capital and provides both the individual and 
the firm a return for years to come, such expenses generally 
are deducted currently rather than capitalized and depreciated 
over time as the benefit is produced. This expensing of 
education and training treats investment in human capital more 
generously than most investments in physical capital, which 
generally are capitalized and depreciated over time. An 
investment in human capital would therefore be more attractive 
after-tax than an investment in physical capital which produced 
the same pre-tax return.
    For workers, employer-provided education and training is 
excluded from their taxable income, and is therefore tax-free, 
if it maintains or improves their skills for their current 
jobs. Even if it does not relate to their current jobs, the 
cost of education (but not graduate-level courses) up to $5,250 
per year provided by an employer under a section 127 education 
plan may be excluded from workers' taxable earnings. 
Educational expenses paid by an employer outside of a section 
127 plan are included in the employee's gross income if the 
education (1) relates to certain minimum educational 
requirements, (2) enables the employee to work in a new trade 
or business, or (3) is unrelated to the current job altogether. 
Section 127, which is scheduled to expire for courses beginning 
after December 31, 2001 lowers the cost to the employee of 
education and training (relative to paying for it out of after-
tax income) and thereby encourages the worker to undertake more 
investment in human capital.
    Education and training expenses incurred by a student (or 
by a family on his/her behalf) generally are not provided 
special tax treatment. However, an employee's education 
expenses needed to maintain or improve a skill required for the 
taxpayer's current job and not reimbursed by an employer are 
deductible to the extent that the expenses, along with other 
miscellaneous deductions, exceed two percent of the taxpayer's 
adjusted gross income. In addition, individuals may claim a 
nonrefundable Hope Scholarship credit of up to $1,500 per 
eligible student for qualified tuition and related expenses 
incurred during the first two years of post-secondary 
education. Finally, taxpayers may claim a nonrefundable 
Lifetime Learning credit for post-secondary or graduate 
education tuition and related expenses, up to a maximum credit 
of $1,000 per family ($2,000 after 2002). These education 
credits phase out for certain higher-income taxpayers.
    The Administration's Budget for FY 2001 includes several 
proposals to further encourage individuals and employers to 
undertake more education and training.
    (1) The College Opportunity Tax Cut would expand the 
current-law Lifetime Learning credit by increasing the credit 
rate (from 20 percent to 28 percent) and by raising the income 
range over which the credit would be phased out (by $10,000 for 
singles and by $20,000 for joint returns). It would also allow 
taxpayers to elect to take an above-the-line deduction for 
qualified tuition and expenses in lieu of the Lifetime Learning 
credit. By lowering the after-tax cost of post-secondary 
education, the College Opportunity Tax Cut would encourage 
families and workers to invest in the training and education 
they most need to prepare for and keep up with the demands of 
the new economy.
    (2) The Administration would expand the section 127 
exclusion for employer-provided education to include graduate 
courses beginning after July 1, 2000 and before January 1, 
2002. As the economy becomes more technologically advanced, 
cutting-edge skills and information necessary for continued 
growth are increasingly disseminated in graduate-level courses. 
Graduate education is an important contributor to the human 
capital of the labor force. The Administration also wishes to 
continue working with Congress to extend section 127 for both 
undergraduate and graduate courses beginning after 2001.
    (3) The Administration has proposed a tax credit for 
employer-provided education programs in workplace literacy and 
basic computer skills. This would allow employers who provide 
certain workplace literacy, English literacy, basic education 
and basic computer training programs to educationally needy 
employees to claim a 20-percent credit, up to a maximum of 
$1,050 per participating employee per year. With the increasing 
technological level of the workplace of the 21st century, 
workers with low levels of education will fall farther behind 
their more educated co-workers and run greater risks of 
unemployment. Lower-skilled workers are less likely to 
undertake needed education themselves, and employers may 
hesitate to provide general education because the benefits of 
basic skills and literacy education are more difficult for 
employers to capture than the benefits of job-specific 
education. The proposed credit will serve those most in need of 
help in getting on the first rung of the technological ladder.
    The Administration strongly supports these three proposals 
as part of its overall efforts to maintain and enhance the 
skill of the workforce. These proposals would encourage 
investment in human capital so that workers, wherever they fall 
on the education spectrum and wherever they are in their 
working years, can obtain and hone the skills necessary for the 
economy now and in the future.

               Tax Proposals to Bridge the Digital Divide

    Access to computers and the Internet and the ability to use 
this technology effectively are becoming increasingly important 
for full participation in America's economic, political, and 
social life. Unfortunately, unequal access to technology by 
income, educational level, race, and geography could deepen and 
reinforce the divisions that exist within American Society. The 
Administration believes that we must make access to computers 
and the Internet as universal as the telephone is today -in our 
schools, libraries, communities, and homes.
    In recognition of the importance of technology in the new 
economy, the President's FY 2001 Budget includes a series of 
tax incentives to ensure that residents of disadvantaged 
communities are able to develop the skills that will be 
essential for labor market success in the coming years. This 
initiative, to help ``bridge the digital divide,'' consists of 
three components. The first initiative, discussed above, is a 
credit to employers who provide training in literacy, basic 
education, and basic computer skills to educationally 
disadvantaged workers.
    The second measure, designed to encourage corporate 
donations of computer equipment, builds upon and extends a 
similar provision of the Taxpayer Relief Act of 1997. Under the 
1997 legislation, a taxpayer is allowed an enhanced deduction, 
equal to the taxpayer's basis in the donated property plus one-
half of the amount of ordinary income that would have been 
realized if the property had been sold. This enhanced 
deduction, limited to twice the taxpayer's basis, was made 
available to donors for a limited three-year period. Without 
this provision, the deduction for charitable contributions of 
such property is generally limited to the lesser of the 
taxpayer's cost basis or the fair market value. To qualify for 
the enhanced deduction, the contribution must be made to an 
elementary or secondary school. The Administration proposal 
would extend this special treatment through 2004, as well as 
expand the provision to apply to contributions of computer 
equipment to a public library or community technology center 
located in a disadvantaged community.
    The third component is a 50 percent tax credit for 
corporate sponsorship payments made to a qualified zone 
academy, public library, or community technology center located 
in an Empowerment Zone or Enterprise Community. The proposed 
tax credit would provide a substantial incentive that would 
encourage corporations to sponsor such institutions. Up to $16 
million in corporate sponsorship payments could be designated 
as eligible for the 50 percent credit in each of the existing 
31 Empowerment Zones (and each of the 10 additional Empowerment 
Zones proposed in the Administration's FY 2001 Budget). In 
addition, up to $4 million of sponsorship payments would be 
eligible for the credit in each Enterprise Community. This 
credit could induce over $1 billion in sponsorship payments to 
schools, libraries and technology centers, providing innovative 
educational programs to disadvantaged communities.
    The proposed initiatives for employer-provided education 
programs in workplace literacy and basic computer skills, 
corporate sponsorship of qualified zone academies and 
technology centers, and corporate donations of computers will 
help bridge the digital divide. This proposal will help to 
ensure that low-skilled workers receive the training they need 
to improve their job skills, and that disadvantaged communities 
have access to innovative educational programs and computer 
technology.

                               Conclusion

    The Treasury Department's recent depreciation report raised 
issues that would need to be addressed in modifying the present 
cost recovery system and provided possible options for 
modifications in the system. We intended that the report would 
serve as a starting point for a public discussion of 
improvements to the cost recovery system. We applaud your 
efforts, Mr. Chairman, to begin that discussion with this 
hearing, and look forward to working with the Congress on this 
matter.
    The Administration supports the extension of the research 
tax credit. The Administration recognizes the importance of 
technology to our national ability to compete in the global 
marketplace, and the research credit fosters new technology. 
The credit provides incentive for private-sector investment in 
research and innovation that can help improve U.S. productivity 
and economic competitiveness.
    The Administration proposals for education and training -
the College Opportunity Tax Cut, the expansion of employer-
provided education assistance to include graduate courses, and 
the new tax credit for workplace literacy and basic computer 
skills -can help develop the skills necessary for the economy 
of the 21st century. The additional proposed initiatives to 
address the digital divide -the enhanced deduction for 
corporate donations of computers and the credit for corporate 
sponsorship payments to qualified zone academies and technology 
centers -will help to ensure that low-income communities have 
access to innovative educational programs and computer 
technology.
    This concludes my prepared remarks. I would be pleased to 
respond to your questions.
      

                                


    Chairman Houghton. Okay; thanks very much.
    You know, you say this is a good starting point. What's a 
good ending point?
    Mr. Mikrut. Well, I think it depends, Mr. Houghton, on 
where you want to go. We have identified in the studies several 
current-law anomalies that could be addressed immediately. For 
instance, the current system of MACRS has several what are 
called ``cliffs'' and ``plateaus,'' where dissimilar assets are 
grouped together and get the same depreciation treatment, 
whereas, very similar assets are grouped separately and get 
very different treatment. That is one issue that could be 
addressed immediately.
    I think there are several other smaller issues. There are 
certain areas where some simplification could be provided by 
using general asset accounts. This is an approach that's been 
advocated by the AICPA. But most of the complaints that you 
hear about the current depreciation system relate to particular 
assets. Following the 1986 Act, the Treasury had the authority 
to examine and modify class lives to reflect more appropriately 
economic depreciation. This authority was taken back in the 
1988 Act. Treasury, although it can study depreciation lives, 
cannot change the lives. It's now up to the Congress to change 
the lives.
    I think in order to fully reflect what's happening in the 
new economy, one would have to look at all the depreciation 
lives, not just those related to the new economy, because new 
technologies are applied in old industries.
    There are more than 100 class lives, so the task of doing a 
top to bottom analysis of the depreciation system is fairly 
monumental and would take several years and would involve very 
costly data gathering. And so, it is up to the Congress, up to 
the tax writing committees, to try to determine exactly what 
they want to do. Do they want to have a long-term study that 
could resolve some of the controversies throughout the system? 
Or would they prefer to focus on the things that come up 
immediately with respect to certain assets or--
    Chairman Houghton. Long-term is in the eye of the beholder 
in this particular age.
    One other question, and then, I'll turn it over to Mr. 
Coyne. In terms of asset valuation, that there are obviously 
differing depreciation schedules in different countries, and 
with the internationalization of our businesses, both in 
tangible and intangible assets, do you see this coming together 
in some sort of a worldwide pattern?
    Mr. Mikrut. The question that you ask is one that's asked 
frequently, Mr. Houghton, and although it was beyond the scope 
of the study, we have looked at where the United States tax 
depreciation system ranks with most of our major trading 
partners. And what we've found is with respect to equipment, we 
provide incentives for saving and investment that are at least 
equal to and perhaps greater than many of our trading partners.
    Now, it's often difficult to try to isolate one parameter 
of a tax system--depreciation--and say, well, this gives one 
nation a competitive advantage over another. I think you have 
to look at the entire system as a whole, and that complicates 
matters. But on a very broad brush analysis, what we've found 
is that the depreciation methods and lives that we use and how 
we respond to changes in the technology are comparable to many 
of our trading partners.
    Chairman Houghton. Thank you.
    Mr. Coyne?
    Mr. Coyne. Thank you, Mr. Chairman.
    Mr. Mikrut, the research and development tax credit is 
currently on the books for a 5-year period. What would the 
Administration's position be relative to advocates for making 
that a permanent tax credit?
    Mr. Mikrut. The Administration, as you know, Mr. Coyne, has 
supported a long-term extension of the credit and has also 
supported a permanent extension of the credit. We understand 
that the importance of technology to our national ability to 
compete in a global economy depends in part upon the research 
credit, which fosters, as you know, further new technology. Any 
further modification or extension of the credit, I think, 
should be taken in the context of any other tax legislation 
that comes before the Congress.
    Mr. Coyne. I wonder if you could try to explain what your 
view of the disconnect between the ability to fill existing 
jobs in the economy and the lack of training for personnel who 
might want to fill those positions.
    Mr. Mikrut. Mr. Coyne, I think this depends on specific 
pockets of the economy. Clearly, some portions of the economy 
are growing faster than the others. The IT area is growing much 
faster than other segments of the economy, and therefore, the 
demand for a skilled workforce there is more critical than in 
others. And eventually, of course, training and other 
investments have to catch up with those demands.
    In response, the Administration has proposed in its digital 
divide proposal in the budget to provide employers a 20 percent 
tax credit to the extent that it provides basic computer skills 
and other literacy requirements. We think that those provisions 
are important. It supplements the current beneficial treatment 
that training receives under current law; that training 
expenses, generally, are deducted rather than capitalized.
    Mr. Coyne. Thank you.
    Chairman Houghton. Mr. Weller?
    Mr. Weller. Thank you, Mr. Chairman, and Mr. Mikrut, I 
appreciate the time you're taking before our subcommittee 
today. In your testimony, you note that you did not submit any 
specific recommendations, particularly when it comes to 
depreciation treatment and technology, but if I recall 
correctly, I voted in the Tax and Trade Relief Extension Act in 
1998, over 2 years ago, legislation which directed the 
Department of the Treasury to come forward with a study and 
recommendations.
    Can you tell me why 2 years is not long enough to do the 
necessary study to present some recommendations to the 
Congress?
    Mr. Mikrut. Certainly, Mr. Weller. There are over 100 
different assets subject to different depreciation regimes. We 
had 18 months to complete the study. The development of those 
class lives for the 100 assets takes years of analysis. We did 
not necessarily want to be in a position of picking and 
choosing winners and losers, saying we will study the proper 
class life for this asset and not the proper study for this 
other asset.
    Mr. Weller. Sure; well, you know, I think we were all a 
little disappointed, number one, that it took as long as it 
did, because we were expecting it this spring so we could look 
at your recommendations and begin this process, and, of course, 
we received this report during the August recess. So it makes 
it difficult for Congress to move forward during this session 
of Congress, so essentially, we're forced to look at it in the 
coming Congress, the 107th Congress.
    I want to focus on one specific area, depreciation 
treatment of technology and first, do you believe that the tax 
code and depreciation treatment of assets, particularly as it 
comes to technology, do you believe that the current 
depreciation treatment of technology has the potential to 
stymie innovation and stymie the acquisition of leading-edge 
technology to use in the workplace? Do you think the tax code 
has an impact on that?
    Mr. Mikrut. Certainly, Mr. Weller; as I mentioned in my 
opening statement, the extent that tax depreciation is slower 
than economic depreciation creates a disincentive to invest in 
those technologies. The current tax system, because the lives 
and methods are frozen based on industries, essentially, that 
were in existence in the 1960's and 1970's may not reflect new 
industries that have sprung up.
    In addition, the class lives for certain high tech 
equipment--computers, semiconductor manufacturing equipment and 
such--those lives are set by statute. So even if the Treasury 
Department were to come out with a study that would say those 
lives should be shorter, present laws wouldn't allow us to 
change those lives.
    Mr. Weller. Yes; Mr. Mikrut, let's look at something that's 
a pretty basic equipment in every office in America today, and 
that's the office PC. What's the recovery period for your 
desktop PC or my desktop PC if it were owned by private 
industry?
    Mr. Mikrut. It's 5 years, double-declining balance.
    Mr. Weller. Five years? And in your testimony, you stated--
I think it was on page 5--that the Treasury Department was 
unaware of any careful empirical study I believe was the quote 
there that establishes that computers have a useful life 
shorter than 5 years. Can you tell me: has the Treasury 
Department undertaken any empirical study itself?
    Mr. Mikrut. No, it has not, Mr. Weller.
    Mr. Weller. And why not?
    Mr. Mikrut. Generally, Mr. Weller, the studies have been 
mandated by Congress. Congress has generally directed us by 
statute which lives and which pieces of property to study. 
Again, in the present study, we have not chosen to pick and 
choose amongst different--
    Mr. Weller. So you haven't taken any initiative to look 
into that.
    You know, if the current recovery period is 5 years for the 
office PC, and you think about it, 5 years ago, you know, if I 
have the 1995 PC on my desk today, how long it would take me to 
access the Internet. Well, we made some notes here just kind of 
looking back during the last 5 years, development of some of 
the technology in the workplace, and if we were forced to keep 
that 5-year-old computer, 1995, the current chips in a PC with 
an Intel Pentium Pro, an AMD-K5; we've seen three or four 
generations of new chips since then.
    1995, a good PC had 150 megahertz of memory. Today, 500 
megahertz is commonplace. 1995, PCs had a floppy disk. Since 
then, we have been through CD-ROM and now DVD. We now have seen 
Windows 95, 98 and 2000 applications. We're way behind. The 
question I have for you is, you know, if we--your personal 
recommendation: do you believe that 5 years is too long for the 
office PC for depreciation?
    Mr. Mikrut. I think the visceral reaction of everyone whose 
looked at this issue is that 5 years is too long for a PC. I 
think, unfortunately, we would need authority to collect the 
data from taxpayers in order to do a relatively efficient 
study. But I think that this is one issue that is clearly worth 
looking at. In our budget, we take a similar approach with 
respect to high tech in that we would allow expensing for 
software.
    Mr. Weller. Sure; just a quick followup on that. You know, 
when I talk with those who use PCs in the workplace, whether 
it's a small business like an insurance agent or a real estate 
office or whether it's a sizeable company with several hundred 
employees, they tell me that often, they replace these PCs 
about every 12 to 14 months, and a number of us are offering 
legislation which would allow you to expense the PC, fully 
deduct in the year that you purchase it. Do you feel that that 
recognizes economic reality?
    Mr. Mikrut. Well, unfortunately, as you point out, our 
study couldn't tell you if that is economic reality or not, 
because although one taxpayer may hold the computer for a year 
or less, the computer may have some salvage value when it's 
disposed of. So the proper measurement of depreciation would be 
what the taxpayer purchased it for versus what the salvage 
value is over that period of time. There may be a secondary 
market for used computer equipment that would make that 
analysis fairly easy to do relative to other types of property. 
So this is something that we would like to work with you in 
trying to determine.
    Mr. Weller. Mr. Chairman, I've run out of time. Thank you, 
and I look forward to working with you.
    Chairman Houghton. Thanks very much.
    Ms. Dunn, we've got about 7 or 8 minutes, and then, we 
really ought to go. So, Ms. Dunn?
    Ms. Dunn. Mr. Mikrut, those of us who have supported the 
R&D tax credits do so because we want to encourage more 
research. It's estimated that the high tech sector is 
responsible for 30 percent of our economic growth. These are 
good, high-paying jobs. I see them in my district near Seattle, 
Washington. They have dramatically improved our quality of 
life.
    It seems that Treasury is attempting to narrow the scope of 
the credit and make it much more difficult for businesses to 
take advantage of. This is especially true of the, quote, 
common knowledge test that you are, the Treasury, is proposing 
and that an Oklahoma court recently ruled against. Can you tell 
us the justification for deviating from the historic definition 
of qualified research by adding this new language?
    Mr. Mikrut. I think the common knowledge test, Ms. Dunn, is 
trying to attempt to interpret the statute and legislative 
history that says that in order to qualify for the credit, the 
taxpayer must be attempting to discover something. In trying to 
take the theoretical notion of what discovery means, we try to 
apply parameters of what's already known, and let's compare 
that to what the taxpayer is trying to discover.
    We have received several comments on the very issue you 
have raised. The regulations that you're pointing to are 
proposed regulations; they do not have full force and effect 
until they're finalized. We're taking the comments that we've 
received very seriously in developing our next set of guidance.
    Ms. Dunn. That's very good, because we are very concerned 
about this. It's very troublesome for me as I represent 
constituencies at home. They are fearful that they would have 
to have intimate knowledge of what every other company is 
doing, not just in the United States but around the world. So 
I'm happy that you're looking at that.
    I'd like to ask you well, maybe just one question, wrap it 
all into one about the timing on this plan. Can you tell us 
whether Treasury is going to finalize the regs this year, and 
when would that be? And do you expect that the regulations 
would be finalized as-is, or do you expect changes before they 
are passed?
    Mr. Mikrut. We have had a significant amount of comments on 
the regulations. We understand the importance of the 
regulations, both to taxpayers and practitioners in trying to 
plan exactly how they should conduct their research and exactly 
how they would justify the expenditures and the record-keeping. 
So we're trying to take all the comments into account.
    On the IRS' and Treasury's business plan for this year, it 
was envisioned that we try to finalize the regulations this 
year. We've made significant progress on several of the 
comments, and again, we're still on plan to try to get it done 
this year, and I think there will be changes from what you see 
in the proposed regulations.
    Ms. Dunn. Can you estimate a time, a date, when you expect 
them to be finalized?
    Mr. Mikrut. I wish I could, Ms. Dunn. It would be a lot 
easier for me, too, but I can't at this time.
    Ms. Dunn. Thank you.
    Thank you, Mr. Chairman.
    Chairman Houghton. Okay; thanks, Ms. Dunn.
    Mr. Watkins?
    Mr. Watkins. I have only a couple of quick questions. I 
want to refer to, you know, Mr. Tauzin's letter of July 28 
dealing with Section 168. I have been working with a number of 
Native Americans who are affected by 168(j) and also the 42(a) 
reservations and non-Indian land. We're working to try to get 
private sector investments. This expires in 2003. The only 
problem is they've run up to a time situation now where the 
private sector investors are trying to get plans, trying to get 
architectural designs, trying to get an industry ready to go. 
They have become reluctant about trying to make the decision to 
make the investments, and they feel they are losing the 
potential of industry and jobs because of this time shutoff of 
2003.
    Do you have any plans to ask for some extensions of that 
time period? For it to be effective, they're going to have to 
have some extension of those years.
    Mr. Mikrut. I understand your concern, Mr. Watkins. This is 
a similar concern that some have with the R&E credit and any 
other investment incentive such that, in order for business to 
accurately plan to make investments, they need some lead time 
to know what the law is and how long that law will be extended. 
The provision that you're pointing to will need a legislative 
change. This Administration will not be submitting another 
budget, so we won't be able to, in next year's budget, propose 
to extend that further than the current sunset date.
    Mr. Watkins. Would you be willing to provide a letter at 
this time to this Congress to try to have that included in any 
type of tax extension for the Native Americans? Because if 
we're really sincere about wanting to try to help them attract 
private sector jobs, we need to make a move on that, and I 
think it would be--submitting a letter, and I'd like to request 
it; I'd appreciate the Chairman trying to get maybe a letter, 
because we need to move on that. If not, we're just fooling; 
we're just speaking with a forked tongue ourselves about trying 
to help the Native Americans attract private sector jobs and 
build up the private sector economy.
    Mr. Mikrut. We appreciate and we understand and support 
your goals, Mr. Watkins, and the other question is: will a mere 
extension be enough? Or would some other change in the program 
be more effective?
    Mr. Watkins. Well, this was a 10-year program when it 
started, so, you know, if they had another 10 years, it took 
them 5 or 6 years to figure out what was happening there, and 
then, finally, they've gotten rulings. So they could work to 
implement it. Now, the private sector is kind of pulling back. 
So we need another 10-year extension on something like this, 5 
to 10 years, in order for us to make it effective.
    Mr. Mikrut. We understand, Mr. Watkins. And again, the only 
issue I was raising is whether--is it merely the passage of 
time, or should there be some examination of what is more 
effective: the wage credit or the depreciation shorter lives 
that really is the engine to attract the jobs that you're 
seeking to attract?
    Mr. Watkins. I can assure you: I live with Native 
Americans, and I was the only non-Native American, non Indian 
on a baseball team growing up, and if you've put your feet 
under their table like I have and working closely with them, 
they need all the help they can get in order to attract jobs 
and to be able to build jobs in those areas, and I think that 
it would behoove us to try to speak and do what's right.
    Mr. Chairman, I hope that we can request and expedite some 
kind of extension of 168(j) and 42(a) in order to try to help 
the Native Americans.
    Chairman Houghton. All right; fine; thank you. If you do 
that, it will be very helpful.
    So, thank you very much, Mr. Mikrut. We're going to suspend 
these hearings for awhile. We have four votes, and I hope Mr. 
Jalbert, Coleman and company will understand. We'll be right 
back, God and the Speaker willing. Thank you.
    [Recess.]
    Chairman Houghton. Sorry, everybody, but we're through 
voting for awhile, and if we can resume the hearing, I'd like 
to introduce Mr. Jalbert, Chairman, President, and Chief 
Executive Officer of Transcrypt, International on behalf of the 
American Electronics Association; and Dorothy Coleman, Vice-
President of Tax Policy, National Association of Manufacturers; 
Molly Feldman, Vice-President of Tax, Verizon Wireless, on 
behalf of the Wireless Depreciation Coalition; Clifford 
Jernigan, Director of Worldwide Government Affairs, Advanced 
Micro Devices; and Theodore Vogel, Vice-President and Tax 
Counsel of DTE Energy on behalf of Edison Electric Institute 
and Frederick von Unwerth, General Counsel, International 
Furniture Rental Association.
    So, great to have you here, and Mr. Jalbert, will you 
begin?

STATEMENT OF MICHAEL E. JALBERT, CHAIRMAN, PRESIDENT, AND CHIEF 
EXECUTIVE OFFICER, TRANSCRYPT INTERNATIONAL, INC., ON BEHALF OF 
                AMERICAN ELECTRONICS ASSOCIATION

    Mr. Jalbert. Good afternoon, Mr. Chairman and members of 
the Subcommittee. My name is Mike Jalbert, and I am chairman, 
president and CEO of Transcrypt International. My testimony 
today is on behalf of the American Electronics Association, 
also known as the AEA. There are more than 3,000 high-tech 
company members of the AEA, and I thank you for the opportunity 
to testify on the tax code and the new economy.
    I have prepared this PowerPoint presentation, which you can 
see over there on my left, to give a visual demonstration of 
the impact the high-tech industry is making on today's economy 
and to help explain why our tax code needs to catch up to this 
industry.
    The growth in high-tech and correspondingly in high-tech 
jobs has been nothing less than extraordinary in the 1990s. 
High-tech jobs topped 5 million in 1999, adding 1.2 million 
jobs in the span of just 6 years. The wages for these jobs are 
quite impressive. The wage differential between the private 
sector and the so-called high-tech jobs increased from 57 
percent in 1990 to 82 percent in 1998. Additionally, the U.S. 
Federal Reserve--
    Chairman Houghton. Just a minute. Break that down a little 
bit. Say that again.
    Mr. Jalbert. What I just said, Mr. Chairman, is that the 
wage differential between the private sector and the high-tech 
jobs increased from 57 percent in 1990--
    Chairman Houghton. It was plus 57 percent.
    Mr. Jalbert. Plus 57 percent; that's correct; to 82 percent 
in 1998.
    This growth was taking place all over the United States, 
not just in Silicone Valley. For example, my company--
    Chairman Houghton. It's Silicon Valley, not Silicone.
    Mr. Jalbert. You've got it; Silicon Valley.
    [Laughter.]
    Mr. Jalbert. For example, my company, Transcrypt 
International, a wireless equipment leader in communications 
technology, has offices right here in Washington, D.C., but we 
have manufacturing facilities and R&D facilities and offices in 
Lincoln, Nebraska and Waseca, Minnesota and, not surprisingly, 
high-tech is the single largest merchandise exporter in the 
United States.
    This next slide helps to explain the importance of worker 
training tax initiatives. The AEA numbers on high employment 
are actually quite conservative. These numbers are very 
conservative. In 1999, the number of 5 million high-tech jobs 
refers only to jobs with the high-tech industry, not all the 
high-tech jobs throughout the entire U.S. economy.
    The necessity of high-tech expertise is crossing all 
boundaries, and I would suspect that even in your Congressional 
offices you have hired employees with high-tech expertise to 
help you better communicate over the Web with your constituents 
and the larger public. High-tech is everywhere, and the entire 
U.S. economy is hiring high-tech. AEA member companies are 
finding it increasingly difficult to hire and retain highly 
skilled workers.
    Permanently extending the Section 127 employer-provided 
educational assistance exclusion and expanding it to include 
the pursuit of graduate studies will allow high-tech companies 
such as mine to address the skilled workforce shortage by 
providing training for their own employees.
    Turning now to R&D, research and development is a key 
ingredient in the new economy, and that fact is repeated 
throughout the global marketplace. The R&D tax credit was first 
enacted in 1981, and it is no coincidence that industry 
replaced the U.S. Government as the primary R&D spender in that 
year. High-tech is an R&D-intensive industry, and the R&D 
credit provides high-tech and other industries with a critical 
tax incentive to maintain and increase their U.S.-based 
research and development.
    The R&D tax credit is responsible for stimulating U.S. 
investment, wage growth, consumption and exports, which all 
contribute to a stronger economy and a higher U.S. standard of 
living. This credit should be made permanent, and the 
regulations governing the credit should be workable.
    This final slide clearly demonstrates the U.S. technology 
usage rates and growth over just the last few years. 
Interestingly, this growth rate pales in comparison with the 
growth rate of other countries across the globe. The U.S. 
percentage of usage growth is 16 percent for computers, 72 
percent for the Internet and 54 percent for cellular phone 
usage. This increase in usage demonstrates there is nothing 
static about these industries. As the usage rate for high-tech 
equipment increases, the industry will continue to grow and 
innovate.
    Correspondingly, AEA believes that the recovery periods and 
depreciation methods under Section 168 should more accurately 
reflect what is happening in this new economy. Thank you for 
the opportunity to present the Subcommittee with this overview. 
I would be happy to answer any questions you may have.
    [The prepared statement follows:]

Statement of Michael E. Jalbert, Chairman, President, and Chief 
Executive Officer, Transcrypt International, Inc., on behalf of 
American Electronics Association

    Good afternoon Mr. Chairman and members of the 
Subcommittee. My name is Michael E. Jalbert and I am the 
Chairman, President and CEO of Transcrypt International, Inc., 
and my testimony today is on behalf of the American Electronics 
Association (AEA). Transcrypt International, Inc. designs, 
manufactures and markets trunked and conventional radio 
systems, stationary land mobile radio transmitters and 
receivers, including mobile and portable radios, and 
manufactures information security products that prevent the 
unauthorized interception of sensitive voice and data 
communication. The more than 3,000 high-tech company members of 
the AEA and I thank you for the opportunity to testify on the 
Tax Code and the New Economy.
    I wish to provide the Subcommittee with an important 
overview of the New Economy, as much of it is included in the 
membership of AEA. I have prepared this power point 
presentation to give a visual demonstration of the impact the 
high tech industry is making on today's economy and to help 
explain why our tax code needs to catch up to this industry. 
The statistics presented are collected from the various AEA 
Cyber reports, including AEA CyberStates 4.0, AEA CyberNation 
2.0, and AEA CyberEducation. More information on these Cyber 
reports can be obtained from the AEA homepage at http://
www.aeanet.org

[GRAPHIC] [TIFF OMITTED] T8411.001


    The growth in high tech and correspondingly in high tech 
jobs has been nothing less than extraordinary in the 1990's. 
High tech jobs topped 5 million in 1999, adding 1.2 million 
jobs in the span of just six years. The wages for these jobs is 
quite impressive--the wage differential between the private 
sector and high tech jobs increased from 57 percent in 1990 to 
82 percent in 1998. Additionally the U.S. Federal Reserve notes 
that 44 percent of GDP growth in recent years is attributable 
to high tech. This growth is taking place all over the United 
States not just in Silicon Valley. For example, my company, 
Transcrypt International, a wireless equipment leader in 
communications technology has offices right here in Washington, 
D.C. and manufacturing facilities in Lincoln, Nebraska and 
Waseca, Minnesota. And not surprisingly, high tech is the 
single largest merchandise exporter in the United States.
    This quick overview helps to easily explain why the three 
topic areas chosen by the Oversight Subcommittee for 
examination during the course of this hearing on the Tax Code 
and the New Economy are so important: worker training tax 
initiatives, the research and development tax credit and its 
regulations, and updating the depreciation recovery periods and 
methods. As the next slides will demonstrate, AEA specifically 
supports updating the tax code address these important issues 
in the U.S. economy.

[GRAPHIC] [TIFF OMITTED] T8411.002


                    Worker Training Tax Initiatives

    The AEA numbers on high tech employment are actually quite 
conservative. The 1999 number of 5 million high tech jobs 
refers only to jobs within the high tech industry, not all of 
the high tech jobs throughout the entire U.S. economy. The 
necessity of high tech expertise is crossing all boundaries, 
and I would suspect that even in your Congressional offices, 
you have hired employees with high tech expertise to help you 
better communicate over the web with your constituents and the 
larger public. High tech is everywhere, and the entire U.S. 
economy his hiring high tech.

[GRAPHIC] [TIFF OMITTED] T8411.003


    The specific high tech industry product and service 
spectrum covers semiconductors and software to computers, 
Internet and telecommunications systems and services. AEA 
member companies are finding it increasingly difficult to hire 
and retain highly skilled workers. AEA's CyberEducation study 
found that the number of undergraduates with high-tech degrees 
declined 5 percent since 1990. The rapid employment growth 
combined with fewer college graduates has resulted in a 
shortage of highly skilled workers. Permanently extending the 
Section 127 employer-provided educational assistance exclusion 
and expanding it to include the pursuit of graduate studies 
(H.R. 323) would allow high-tech companies to address the 
skilled workforce shortage by providing training for their own 
employees.

Research and Development Tax Credit
    Research and development is a key ingredient in the New 
Economy and that fact is repeated throughout the global 
marketplace. The U.S. trails behind other industrialized 
nations in its investment in R&D.

[GRAPHIC] [TIFF OMITTED] T8411.004


[GRAPHIC] [TIFF OMITTED] T8411.005


    The Research and Experimentation Tax Credit, commonly 
referred to as the R&D tax credit was first enacted in the U.S. 
in 1981 and it is no coincidence that industry replaced the 
U.S. government as the primary R&D spender in that year. This 
important tax provision provides for a research credit equal to 
20 percent of the amount by which a company's qualified 
research expenditures for a taxable year exceeded its base 
amount for that year.

[GRAPHIC] [TIFF OMITTED] T8411.006


    High-tech is an R&D intensive industry, and the R&D credit 
provides high tech and other industries with a critical tax 
incentive to maintain and increase their U.S.-based research 
and development. The R&D tax credit is responsible for 
stimulating U.S. investment, wage growth, consumption and 
exports which all contribute to a stronger economy and a higher 
U.S. standard of living. The R&D tax credit helps most AEA 
member companies (including hardware, software and 
manufacturers), regardless of size who undertake research. 
Enactment of a permanent R&D tax credit (H.R. 823) will enable 
companies to have certainty in their tax planning. AEA strongly 
supported the five-year extension of this credit last year, and 
urges Congress to permanently extend this credit now.
    Additionally, implementation of regulations that accurately 
fulfills the congressional intent behind the credit is of 
paramount importance. AEA defers to this hearing's R&D panel to 
more fully explain the high tech industry's concerns about the 
proposed R&D credit regulations. To quickly summarize, AEA 
along with others in the R&D industries have filed comments 
with Treasury expressing serious concern about the proposed 
regulations. Given the strong comments that have been received 
by Treasury to these regulations, AEA suggests that at a 
minimum Treasury should consider re-proposing these 
regulations.

[GRAPHIC] [TIFF OMITTED] T8411.007


        U.S. Tax Code Depreciation Recovery Periods and Methods

    This final slide clearly demonstrates the U.S. technology 
usage rates and growth over just the last few years. 
Interestingly, this growth rate pales in comparison with the 
growth rate of other countries across the globe. The U.S. 
percentage of usage growth -16 percent for computers, 72 
percent for the Internet, and 54 percent for cellular phone 
usage -demonstrates there is nothing static about these 
industries. As the usage rate for high tech equipment 
increases, the industry will continue to grow and innovate. 
Correspondingly, AEA believes that the recovery periods and 
depreciation methods under Section 168 should more accurately 
reflect what is happening in this New Economy.
    AEA noted with interest the Treasury study that highlighted 
the shortcomings of the current system and which concluded that 
the current depreciation system is dated. Under this current 
regime, only Congress has the authority to change asset class 
definitions or class lives, and the introduction of over 50 
separate bills in the House and Senate during the 106th 
Congress to address this inequity demonstrates how much work is 
yet to be done. Rather than commenting on each of these bills, 
AEA wishes to state the obvious: that tax certainty and 
predictability is of paramount importance. Many subsections of 
the high tech industry are considered to be nascent 
technologies that do not even have identifiable class lives. 
That fact combined with class lives that do not reflect the 
useful life of high tech apparatus such as computers, software, 
semiconductor manufacturing equipment and printed circuit 
boards, is a bad tax combination.
    AEA was very interested in Treasury's proposal to establish 
temporary asset classes for nascent technologies. As such, the 
temporary asset classes would help to provide certainty to 
taxpayers for an initial development period, without disturbing 
the class lives for existing technologies. AEA agrees with 
Treasury that this temporary class designation would provide a 
signal that this asset class will be studied before the 
expiration date of the temporary asset class. This signal would 
be important because often such nascent technologies are too 
busy trying to get their technology up and running rather than 
worrying about how the tax rules should recognize them. 
Similarly, it would avoid placing new assets in an existing 
asset class, where they may not belong, and would avoid placing 
new assets permanently in a ``default'' class with an arbitrary 
class life. AEA concludes its testimony by offering to work 
with Treasury and Congress to address these shortcomings in the 
tax code.
    AEA appreciates the opportunity to present this overview to 
you today. I would be happy to answer any questions you may 
have. Thank you.
      

                                


    Chairman Houghton. Thank you very much.
    What I think we'll do is just go right through the panel 
and then take questions afterwards.
    All right;--is that okay with everybody?
    Okay; Ms. Coleman?

 STATEMENT OF DOROTHY B. COLEMAN, VICE PRESIDENT, TAX POLICY, 
             NATIONAL ASSOCIATION OF MANUFACTURERS

    Ms. Coleman.Chairman Houghton and members of the 
Subcommittee, thank you for the opportunity to appear before 
you today to discuss the tax code and the new economy. My name 
is Dorothy Coleman, and I'm pleased to be here today on behalf 
of the National Association of Manufacturers. The NAM, 18 
million people who make things in America, is the Nation's 
largest and oldest multi-industry trade association. The NAM 
represents 14,000 member companies, including 10,000 small and 
mid-sized manufacturers.
    NAM members have long held the belief that the current tax 
system is a major obstacle to realizing the full potential of 
our economy. We need a new tax system that is simpler and 
encourages rather than penalizes work, investment and 
entrepreneurial activity, and that is competitive with that of 
our foreign trading partners. Specific changes endorsed by the 
NAM including savings incentives, a single tax system for 
businesses, elimination of the double taxation of corporate 
earnings, fair and equitable transition rules, and more rapid 
recovery of capital equipment costs.
    All businesses, whether considered old or new economy, will 
benefit from a pro-growth tax system designed for a 21st 
Century economy. In fact, the distinction between the old and 
new economies is largely artificial. The term old economy 
brings to mind belching smokestacks, blue-collar workers, dirty 
factories, bricks and mortar, all aimed at making tangible 
things. In contrast, new economy represents high-tech gadgetry, 
skilled workers, whistle-clean factories, computers and 
microprocessors.
    In reality, though, this clear-cut distinction is not an 
accurate picture of either the economy or the modern 
manufacturing world. The integration of traditional 
manufacturing with the technological innovation of the past 
decade has transformed our entire economy. This convergence has 
been going on for more than a decade and has already created 
what we at the NAM call new manufacturing.
    A hallmark of our current robust economy is the remarkable 
advances in technology that are changing everything about the 
way our economy functions. Technology is the single biggest 
contributor to economic growth. The fact that manufacturing is 
also the single biggest beneficiary of technology underscores 
our insistence that the currently fashionable distinction 
between the old economy and the new economy is a distinction 
without a difference.
    Technology has led to a boom in productivity. The rate of 
manufacturing productivity growth was nearly 5 percent from 
1996 through 1999, double that of the overall business sector, 
as it has been since 1992. This strong, steady increase in 
productivity has enabled the economy to achieve strong growth 
without significant inflation. Over the past 3 years, the U.S. 
economy has averaged noninflationary growth of about 4 percent. 
We would like to see this economic growth continue; a tax 
policy that stops discriminating against capital investment is 
essential to continued economic growth.
    The pro-growth tax policy we need must encourage businesses 
to increase capital formation in the United States. One of the 
most effective ways to spur business investment, which, in 
turn, will lead to continued technological advances and 
productivity growth, is through an enhanced capital cost 
recovery system. In particular, the NAM supports moving towards 
an accelerated depreciation system that shortens depreciation 
lives to one year.
    Under this accelerated system, companies could expense 
capital equipment in the tax year it was purchased. An integral 
part of a system is eliminating the current corporate 
alternative minimum tax. By its very nature, the AMT punishes 
both individuals and businesses. We commend the Ways and Means 
Committee for taking the lead in 1997 to soften the anti-
investment impact of the AMT and provide needed relief to many 
companies. Nonetheless, unless the AMT is totally eliminated, 
larger deductions for capital investments will push companies 
into an AMT situation forcing them to use longer depreciation 
periods.
    Expensing represents a significant departure from our 
current depreciation system. It is imperative that the 
transition from the current system to expensing provides fair 
and equitable treatment for taxpayers who made business 
decisions based on current law. A basic premise of economic 
theory is that investment is a positive function of an increase 
in demand and a negative function of cost. The cost of capital 
to a firm includes three components: the price of capital 
goods; the cost of funds to the firm; and the tax treatment of 
investment. Expensing lowers the cost of capital and thus leads 
to increased investment.
    We agree with the Treasury report that the current 
depreciation system is dated and that changing the current 
system would be a costly and time-consuming undertaking. 
Determining class lives alone would consume valuable Treasury 
time and resources. In contrast, expensing of capital 
investments would be a simple and direct solution.
    The goal of a capital recovery system should be to make 
capital more available; help American businesses keep pace with 
technological change; improve the competitiveness of American 
goods in world markets; simplify tax compliance and minimize 
the erosive effect of inflation on invested capital. A system 
that provides for immediate expensing achieves these goals. 
Moreover, workers also benefit from an enhanced capital cost 
system. Increased investment raises labor productivity, which 
leads to higher wages.
    The enhanced capital cost recovery system described here 
today doesn't differentiate between old economy and new economy 
businesses. It benefits all businesses that invest in capital 
goods. On behalf of the NAM, thank you for inviting me here to 
discuss this important issue.
    [The prepared statement follows:]

Statement of Dorothy B. Coleman, Vice President, Tax Policy, National 
Association of Manufacturers

    Chairman Houghton and members of the subcommittee, thank 
you for the opportunity to appear before you today to discuss 
the tax code and the new economy.
    My name is Dorothy Coleman, and I am pleased to be here 
today to testify on behalf of the National Association of 
Manufacturers. The NAM -'18 million people who make things in 
America' -is the nation's largest and oldest multi-industry 
trade association. The NAM represents 14,000 member companies 
(including 10,000 small and mid-sized manufacturers) and 350 
member associations serving manufacturers and employees in 
every industrial sector and all 50 States. We're headquartered 
in Washington, D.C., and we have 10 additional offices across 
the country.
    NAM members have long held the belief that the current tax 
system is a major obstacle to realizing the full potential of 
our economy. We need a new tax system that is simpler and 
encourages, rather than penalizes, work, investment and 
entrepreneurial activity, and that is competitive with the 
systems of our foreign trading partners. Specific and systemic 
changes endorsed by the NAM include savings incentives; a 
single tax system for businesses, with no additional components 
like the alternative minimum tax and no net tax increase on 
businesses; elimination of the double taxation of corporate 
earnings; fair and equitable transition rules and more rapid 
recovery of capital equipment costs.
    Clearly, all businesses, whether considered ``old'' or 
``new'' economy, will benefit from a pro-growth tax system 
designed for a 21st century economy. In fact, the distinction 
between the ``old'' and ``new'' economies is largely 
artificial. The term ``old economy'' brings to mind belching 
smokestacks, blue-collar workers, dirty factories, bricks and 
mortar -all aimed at making tangible things. In contrast, ``new 
economy'' represents high-tech gadgetry, skilled workers, 
whistle-clean factories, computers and microprocessors. Its 
pace is quick, its productivity is high and its rate of change 
is as fast as the Internet.
    In reality, though, this clear-cut distinction is not an 
accurate picture of either the economy or the modern 
manufacturing world. The integration of traditional 
manufacturing with the technological innovations of the past 
decade has transformed our entire economy. This convergence has 
been going on for more than a decade and has already created 
what we at the NAM call ``new manufacturing.''
    New manufacturing is not just a part of the new economy; 
it's one of the reasons we have it in the first place. We would 
not have today's new economy, with its seemingly durable high 
growth and low inflation, if it weren't for new manufacturing 
products (technology), processes (just-in-time inventories, for 
example), people (the best workers in the world) and 
productivity (made possible by all of the above).
    A hallmark of our current robust economy is the remarkable 
advances in technology that are changing everything about the 
way our economy functions. Technology is the single biggest 
contributor to economic growth, and manufacturing is the single 
biggest contributor to technology. Based on data from the U.S. 
Departments of Commerce and Labor and from the National Science 
Foundation, manufacturing accounts for nearly 60 percent of 
annual advances in technology. The fact that manufacturing is 
also the single biggest beneficiary of technology underscores 
our insistence that the currently fashionable distinction 
between the old economy and the new economy is a distinction 
without a difference.
    Technology, in turn, has led to a boom in productivity. The 
rate of manufacturing productivity growth was nearly 5 percent 
from 1996 through 1999, double that of the overall business 
sector, as it has been since at least 1992. This strong, steady 
increase in productivity has enabled the economy to achieve 
strong growth without significant inflation.
    Over the past three years, the U.S. economy has averaged 
non-inflationary growth of about 4 percent. We would like to 
see this economic growth continue. Needless to say, growth like 
that in the next decade cannot be taken for granted. A pro-
growth tax policy that stops discriminating against capital 
investment is essential to continued economic growth.
    In my remarks today, I'd like to focus on the tax treatment 
of physical capital, like plants and equipment. NAM Board 
member Collie Hutter, chief operating officer of Click Bond 
Inc. in Carson City, Nev., will discuss the tax treatment of 
research and development in her testimony before the 
subcommittee on September 28.
    The pro-growth tax policy we need must encourage businesses 
to increase capital formation in the United States. One of the 
most effective ways to spur business investment, which in turn 
will lead to continued technological advances and productivity 
growth, is through an enhanced capital-cost recovery system. In 
particular, the NAM supports moving toward an accelerated 
depreciation system that shortens depreciation lives to one 
year.
    Under this accelerated depreciation system, companies could 
expense capital equipment in the tax year it was purchased. An 
integral part of an accelerated depreciation system is 
eliminating the current corporate alternative minimum tax (AMT) 
system. By its very nature, the AMT punishes both individuals 
and businesses. We commend the House Ways and Means Committee 
for taking the lead in 1997 to soften the anti-investment 
impact of the AMT. Conforming AMT depreciation periods with 
regular corporate tax depreciation periods provided needed 
relief to many companies. Nonetheless, unless the AMT is 
totally eliminated, the larger deductions for capital 
investments under an accelerated depreciation system would push 
companies into an AMT situation, forcing them to use longer 
depreciation periods.
    Fair and workable transition rules also are critical to the 
success of an accelerated depreciation system. Expensing 
represents a significant departure from our current 
depreciation system. It is imperative that the transition from 
the current system to a new one provides fair and equitable 
treatment for taxpayers who made business decisions based on 
current law. In particular, since manufacturing is a capital-
intensive industry, many of our members have sizable amounts of 
remaining tax basis that might be lost altogether if expensing 
is applied to all capital. While our members support current 
expensing, it is important to include transition rules that 
allow companies to utilize accrued, but unused, tax attributes.
    The positive economic impact of accelerated depreciation is 
straightforward. A basic premise of economic theory is that 
investment is a positive function of an increase in demand and 
a negative function of costs. The cost of capital to a firm 
includes three components: the price of capital goods, the cost 
of funds to the firm and the tax treatment of investment. 
Expensing lowers the cost of capital and thus leads to 
increased investment. In this respect, the marginal cost of 
capital depends on the depreciation rate applied to new 
investments. The depreciation rate applied to old capital does 
not change the cost of capital at the margin. However, write-
off of old capital reduces the average corporate tax rate, 
leading to higher after-tax profits, larger dividend payouts 
and higher stock values.
    We agree with the Treasury Department's conclusion in its 
``Report to Congress on Depreciation Recovery Periods and 
Methods,'' that the current system is dated and that changing 
the current system would be a costly and time-consuming 
undertaking. Determining class lives alone would consume 
valuable Treasury time and resources. In contrast, expensing of 
capital investments would be a simple, direct and expeditious 
solution.
    The goal of a capital recovery system should be to make 
capital more available, help American businesses keep pace with 
technological change, improve the competitiveness of American 
goods in world markets, simplify tax compliance and minimize 
the erosive effect of inflation on invested capital. A system 
that provides for immediate expensing achieves these goals. 
Moreover, workers also benefit from an enhanced capital-cost 
recovery system. Increased investment raises labor 
productivity, which leads to higher wages.
    Higher non-inflationary growth demands higher productivity, 
which, in turn, leads to higher compensation. That's a pretty 
good formula for success. Federal tax issues that foster this 
formula are critical to the continued leadership of the United 
States in the international marketplace. The enhanced capital-
cost recovery system described here today doesn't differentiate 
between old economy and new economy businesses. It benefits all 
businesses that invest in capital goods.
    On behalf of the NAM, thank you for inviting me here today 
to discuss this important issue.
      

                                


    Chairman Houghton. Thanks very much, Ms. Coleman.
    Ms. Feldman?

  STATEMENT OF MOLLY FELDMAN, VICE-PRESIDENT OF TAX, VERIZON 
  WIRELESS, ON BEHALF OF CELLULAR TELECOMMUNICATIONS INDUSTRY 
                          ASSOCIATION

    Ms. Feldman. Chairman Houghton and members of the Oversight 
Committee, thank you for the opportunity to testify and for 
holding these hearings on the tax code and the new economy. My 
name is Molly Feldman, and I am Vice-President of Tax at 
Verizon Wireless. Verizon Wireless and the Cellular 
Telecommunications Industry Association, which represents 
nearly 400 companies in all areas of the wireless industry, 
seek greater clarity in the depreciation rules governing our 
industry.
    We support the premise in the press release announcing the 
subcommittee's hearing that the Internal Revenue Code's 
depreciation system is very outdated and fails to adequately 
address the cost recovery needs of the Nation's new, high-
technology based economy. The wireless telecommunications 
industry, like many other high-technology industries, depends 
on computer-based technology to facilitate the digitization of 
voice, video and data over its new digital networks.
    The first steps in the development of the current wireless 
system started with the creation of a computer-controlled 
network of cells which contained low-powered, computer-based 
switching equipment. It was the introduction of the computer to 
the system of cell sites that enabled the cellular system to 
provide call handoffs as a mobile user passed through its 
designated geographic area. Computers are used to provide all 
required functions and are predominant in all parts of the 
system.
    Wireless companies are continuously replacing equipment due 
to obsolescence. For example, much of the upgraded digital 
wireless equipment that only recently replaced analog equipment 
beginning in the mid-1990s is itself expected to be replaced in 
a few short years due to the emergence of the next generation 
of equipment. The increasing speed with which this is 
occurring, just as in the computer industry, has rendered many 
billions of dollars worth of equipment obsolete.
    The Treasury Department's recently released report to the 
Congress on depreciation recovery periods and methods 
recognizes that innovation in the information age has created 
many new industries that are not clearly addressed by current 
depreciation rules. The report points out that the wireless 
telecommunications industry was in its infancy when the current 
asset classes were defined and that its digital technology does 
not fit appropriately into the existing definitions for wired 
telephony related classes.
    The wireless telecommunications industry is one of the 
fastest growing industries in the United States with more than 
100 million Americans that currently subscribe to wireless 
service. Job growth in the wireless industry supplied just over 
4,300 American jobs in 1986. By 1999, over 155,000 jobs were 
created, and the industry was responsible for creating another 
million jobs in supporting and related industries.
    Rapid technological innovation has resulted in an evolving 
industry that originally provided voice communications to one 
that increasingly works as a network providing computer 
functionality. New, third-generation products, sometimes 
referred to as 3G, will provide much-improved services to 
remote users, including enhanced voice and high-speed data 
links to office computers; the ability to send and receive 
faxes; high-speed Internet connectivity; video transmission and 
videoconferencing.
    Wireless companies plan to expand wireless networks into 
new markets and rural areas with the goal of uninterrupted 
service throughout North America. Continued investment in 
network upgrades and expansion will continue to improve local 
economies and will permit the increased availability of mobile 
data services, providing Internet access to many urban, rural 
and suburban communities.
    Not only has the increase in wireless subscribership driven 
job growth, but it has also increased capital spending. In 
1985, total capital spending on wireless telecommunications 
equipment amounted to $526 million. By 1999, annual capital 
expenditures had exceeded $15 billion. Unfortunately, without 
clear depreciation rules which reflect the true useful life of 
wireless telecommunications equipment, continued investment 
might be limited or deferred.
    As you know, the cost of most tangible depreciable property 
placed in service after 1986 is recovered using the modified 
accelerated cost recovery system. Under this system, assets are 
grouped into classes of personal property and real property, 
and each class is assigned a recovery period and depreciation 
method. The commercial wireless telecommunications industry was 
in its infancy in 1986 and 1987 when the depreciation system 
was last revised. As a result, the rules which are currently 
being applied by the IRS and by the wireless industry were 
originally developed without specifically considering the 
characteristics of wireless telecommunications equipment.
    Both wireless telecommunications companies and the IRS have 
expended significant resources over the past few years auditing 
and settling disputes involving the depreciation of wireless 
telecommunications equipment. Because of the rapid 
technological changes, we believe that the maximum recovery 
period that should be applied is 5 years. Clearly, the 
appropriate class life of cellular telecommunications assets 
does not approach 10 years, let alone the 16 to 20 years often 
argued by the IRS. As a result of these continuing disputes and 
the lack of clear guidance, we believe Congress must clarify 
the depreciable life of these assets.
    The inappropriate assignment of assets to depreciation 
classes with longer recovery periods has a huge impact on the 
cost of investment borne by wireless companies. The 
misclassification of wireless telecommunications assets imposes 
an unfair level of taxation on wireless companies compared to 
other companies utilizing assets that have properly defined 
class lives. The burden of these unfair taxes is ultimately 
borne by the subscribers of wireless telecommunications 
service, whose cost of service is higher than it would 
otherwise be as well as potential users of wireless systems who 
may be precluded from becoming subscribers due to decreased 
investment and slower build-out.
    Rather than shoe-horn wireless telecommunications equipment 
into wire-line telephony classes, as some would do, the better 
solution would be to include wireless telecommunications 
equipment within the definition of qualified technological 
equipment. The code currently defines such equipment to include 
any computer or peripheral equipment and any high-technology 
telephone station equipment installed on a customer's premises. 
Wireless equipment is properly characterized as 5-year, 
qualified technological equipment because of the fact that the 
predominant components of wireless networks are, in fact, 
computers.
    A depreciable life of anything greater than 5 years will 
penalize this fast-growing industry and limit the capital 
available for the continued expansion of an advanced wireless 
digital network. Such a network would allow wireless 
telecommunications companies to continue to pursue business 
objectives which translate into continued job growth, 
productivity gains and overall economic expansion.
    To ensure depreciation certainty in the future, Congress 
should recognize these changes are occurring in the information 
age and be prepared to shorten depreciable lives for assets 
that are the foundation of the new economy.
    We understand that Congressman Phil Crane will be 
introducing legislation in the next several days that provides 
for this important clarification. We encourage the members of 
this committee to join Congressman Crane in addressing this 
problem.
    In summary, depreciation guidance for the wireless 
telecommunications industry is needed to provide clarity and 
avoid controversy leading to unnecessary costs to both the 
Government and industry. The current depreciation system should 
be revised to clarify that all wireless telecommunications 
equipment is included in the qualified technological equipment 
category.
    I'll be pleased to try to answer any questions you may have 
regarding my testimony.
    [The prepared statement follows:]

Statement of Molly Feldman, Vice President of Tax, Verizon Wireless on 
behalf of Cellular Telecommunications Industry Association

    Chairman Houghton and Members of the Oversight 
Subcommittee, thank you for holding these hearings on the tax 
code and the new economy. My name is Molly Feldman and I am 
Vice President of Tax at Verizon Wireless. I am appearing 
before you today on behalf of a coalition of national and 
regional wireless telecommunications companies which have 
banded together to seek greater clarity in the depreciation 
rules governing our industry. In addition, the Cellular 
Telephone Industry Association endorses our recommendation that 
depreciable lives for wireless telecommunications equipment 
should be clarified to encourage continued investment in the 
new economy. We support the premise in the press release 
announcing the Subcommittee's hearing that the Internal Revenue 
Code's depreciation system is outdated and fails to adequately 
address the cost recovery needs of the nation's new high 
technology-based economy.
    The wireless telecommunications industry provides a 
textbook example of the shortcomings of the current tax 
depreciation system for emerging high technology industries. 
Like so many other high technology industries, the wireless 
telecommunications industry depends on computer-based 
technology to facilitate the digitization of voice, video and 
data over the industry's new digital networks.
    The first steps in the development of the current wireless 
system started with the creation of a computer-controlled 
network of ``cells,'' which contained low-powered computer-
based switching equipment. It was the introduction of a 
computer to the system of cell sites that enabled the wireless 
system to provide call hand-offs as a mobile user passed 
through its designated geographic area, allowing the wireless 
system to reuse its limited frequency for another wireless 
user. Computers are used to provide all the required functions 
and are present in all parts of the system. Without the use of 
computers, it is not practical or economical to implement a 
wireless system.
    The wireless PCS license auctions in 1993 and 1994 created 
heightened competition and led to an accelerated change-out of 
technology, particularly the conversion from analog to digital 
equipment. Wireless companies are continuously replacing 
equipment due to functional or technical obsolescence. For 
example, much of the upgraded digital wireless equipment that 
only recently replaced analog equipment beginning in the mid-
1990s is itself expected to be replaced within the next three 
to four years due to the emergence of the next generation of 
equipment. The increasing speed with which this phenomenon is 
occurring has rendered many billions of dollars worth of 
equipment obsolete, as well as shortened both service and 
economic lives.
    The Treasury Department's recently released ``Report to the 
Congress on Depreciation Recovery Periods and Methods'' makes 
the point that the rapid pace of innovation in the information 
age has created many new industries like the wireless industry 
that are not clearly addressed by current depreciation rules. 
The report points out that the wireless industry did not exist 
when the current assets classes were defined and that its 
digital technology does not fit well into the existing 
definitions for wired telephony-related classes.\1\
---------------------------------------------------------------------------
    \1\ Department of the Treasury, ``Report to Congress on 
Depreciation Recovery Periods and Methods,'' July 2000.

The Importance and Growth of the Wireless Telecommunications 
---------------------------------------------------------------------------
Industry

    The wireless telephone industry has been one of the fastest 
growing industries in the United States since the mid-1980s. 
The growth in the industry, in terms of subscribership and 
capital investment, has taken place at a much faster rate than 
predicted in even the most optimistic forecasts. According to 
the most recent Cellular Telephone Industry Association (CTIA) 
Semiannual Wireless Survey, 86 million Americans subscribed to 
wireless service in 1999, and analysts project 175 million 
subscribers by 2007.
    The growth in wireless subscribers has had a dramatic 
effect on the U.S. economy in terms of job creation. The 
wireless industry directly supplied 4,334 American jobs in 
1986. By 1999, the wireless industry directly supplied over 
155,000 jobs and was responsible for creating another million 
jobs in industries that support wireless telecommunications. 
The wireless industry is part of the high technology community 
that is the engine of our economic prosperity, creating new 
jobs and new opportunities for all Americans.
    The rapid pace of technological innovation that has 
characterized the wireless industry in the past will continue 
and even increase in the future. The wireless industry is 
evolving from an industry that provided primarily voice 
communications services to one that increasingly works as a 
network providing computer functionality, such as Internet 
access. New third-generation (``3G'') products will provide 
similar, much improved, services to remote users. Anticipated 
uses for new technologies include enhanced voice and high-speed 
data links to office computers, the ability to send and receive 
faxes, high-speed Internet connectivity, video transmission and 
video conferencing.
    Wireless companies plan to expand wireless networks into 
new markets and rural areas with the goal of uninterrupted 
service throughout North America. The current expansion in 
networks has distributed the job growth from metropolitan areas 
to some of the most rural parts of the country. Continued 
investment in network upgrades and expansion will continue to 
have a positive effect on local economies throughout the 
country. Mobile data services available over the new wireless 
digital networks will permit increased expansion of Internet 
access into urban, rural and suburban communities,
    Not only has the increase in wireless subscribership driven 
job growth, but it has also produced a commensurate increase in 
capital spending to deploy new technology and expand wireless 
networks. In 1985, total capital spending on wireless assets 
amounted to $526 million. Annual capital expenditures on 
wireless assets exceeded $15 billion in 1999. Capital spending 
at the current levels make clear depreciation rules a priority, 
but such clarity is exactly what is lacking under our current 
depreciation system.

History of the Wireless Telecommunications Industry

    Cellular telecommunications technology was first created in 
AT&T's laboratories in the 1940s. The technological precursor 
of cellular telecommunications was called Mobile Telephone 
Service (``MTS'') and consisted of one large broadcasting tower 
and a high-powered transmitter which had a range of 
approximately 50 miles. In addition to this range restriction, 
the system was further limited by the size of the transmitter, 
bandwidth constraints and a small user capacity. Another key 
limitation was that the MTS could only be used within the 
specific geographic location of the tower. The MTS could not 
hand off calls to other towers as the user moved outside the 
``home'' area. These limitations doomed this technology from 
ever becoming commercially feasible.
    The first modern cellular system -which the industry now 
refers to as ``wireless''--was called Advanced Mobile Phone 
Service (``AMPS''). This system was designed to address the 
technological limitations posed by MTS. The single base station 
in the MTS system was replaced with a computer-controlled 
network of ``cells,'' which contained low-powered computer-
based switching equipment. It was the introduction of a 
computer to the system of cell sites that enabled the wireless 
system to provide call hand-offs as a mobile user passed 
through its designated geographic area, allowing the system to 
reuse its limited frequency for another wireless user. It 
should be clear that computers are used to provide all the 
required functions, and that these computers are present in all 
parts of the system. Without the use of computers, it is not 
practical or economical to implement a wireless system.
    As a result of Federal Communications Commission (FCC) 
action in 1981 that created a duopoly in 48 Metropolitan 
Statistical Areas (MSAs), the first commercially viable AMPS 
system was launched in October 1983 in Chicago. Since then, the 
wireless industry has grown into a major industry that has 
played a significant role in the economic growth in the 1990s. 
The FCC auction of 30 MHz Personal Communications Systems (PCS) 
licenses during 1993 and 1994, as well as the passage of the 
Telecommunications Act of 1996, has significantly increased 
investment and competition within the telecommunications 
industry. The growth in the wireless industry is due to the 
technological advances that have allowed wireless companies to 
meet consumer demand and still offer affordable wireless 
service to a growing consumer base.

Technological Advances and the Speed of Change

    Consumer demand for wireless service has increased at a 
phenomenal rate. Although the wireless industry has benefitted 
greatly from the strong demand for its products, the industry 
has also been forced to aggressively pursue technological 
solutions to address bandwidth limitations in order to keep up 
with increased competition from new entrants into the wireless 
market using the latest digital technologies.
    The PCS license auctions in 1993 and 1994 created 
heightened competition in the wireless industry. This led to an 
accelerated change-out of technology, particularly the 
conversion from analog to digital equipment. The increasing 
speed with which this phenomenon is occurring has rendered many 
billions of dollars worth of equipment obsolete, as well as 
shortened both service and economic lives.
    Telecommunications technology is progressing at a rate that 
has previously only been seen in the personal computer (PC) 
industry. Gordon Moore, co-founder and Chairman Emeritus of 
Intel Corporation, stated in a speech in 1965, that the pace of 
technology change is such that the amount of data storage that 
a microchip can hold doubles every year or at least every 18 
months. Moore's observation, now known as Moore's Law, 
described a trend that has continued and is still remarkably 
accurate. It is the basis for many planners' performance 
forecasts.
    Moore's law is easily applied to changes that have occurred 
with wireless telecommunications equipment. The cost of 
equipment has remained fairly constant while equipment 
capabilities have continued to increase exponentially. The 
striking similarity between the PC industry and the wireless 
equipment industry is due in large part to the fact that the 
major components of a cell site are in fact computers or 
peripheral equipment controlled by computers.
    Wireless companies are continuously replacing equipment due 
to functional or technical obsolescence. For example, much of 
the upgraded digital wireless equipment that only recently 
replaced analog equipment beginning in the mid-1990s is itself 
expected to be replaced within the next three to four years due 
to the emergence of the next generation of equipment.

The Future of Wireless Technology

    The rapid pace of technological innovation that has 
characterized the wireless industry in the past will continue 
and even increase in the future. The wireless industry will 
evolve from an industry that provides primarily voice 
communications services to one that increasingly works as a 
network providing computer functionality, such as Internet 
access. New third-generation products will provide similar, 
much improved, services to remote users. Anticipated uses for 
new technologies include enhanced voice and high-speed data 
links to office computers, the ability to send and receive 
faxes, high-speed Internet connectivity, video transmission and 
video conferencing.
    In addition, governmental actions may necessitate wireless 
carriers to purchase new equipment to meet government mandates. 
Currently, the wireless telephone is in the process of 
complying with FCC requirements to implement enhanced 911 
service. Enhanced 911 (``E911'') service provides emergency 
service personnel with the telephone number and location of a 
caller reporting the need for emergency services. This 
information is used to more rapidly dispatch help and to enable 
the emergency personnel to call the user back at the same 
number should the call become disconnected.
    Both the technological changes taking place in the wireless 
industry and new government regulations will require wireless 
companies to make substantial capital investments implementing 
new technology. These rapidly-approaching events serve to 
highlight the critical importance of depreciation rules that 
accurately reflect the future state of the industry.

The Components of Wireless Telecommunications Systems

    The three primary components of a wireless 
telecommunications system--cell sites, mobile switching centers 
and handsets--work together as an integrated network to provide 
wireless telecommunications services. Each cell site consists 
of computer-based assets, which operate as a coordinated unit 
that is directly connected to a mobile switching center via a 
microwave transmitter or other dedicated transmission facility. 
A cell site's computer-based assets are driven by advanced 
software programs that encode and decode analog and digital 
data through complex algorithms; that monitor and adjust the 
power transmission levels of wireless handsets allowing 
customers to receive and deliver calls within a particular cell 
radius (ensuring quality reception); and that enable call hand-
off as subscribers pass from one cell to the next.
    Compared to traditional landline telephone systems, the 
functions of wireless telecommunications systems are highly 
decentralized--being allocated among the mobile switching 
centers and cell sites which comprise these systems. Without 
the complex, software-driven functionality of the equipment at 
both the cell sites and the mobile switching centers, the 
successful coordination of these decentralized functions would 
be impossible, as would be wireless telecommunications itself.

Description of a Cell Site

    The equipment at a cell site includes computers as well as 
equipment that is under the control of computers located at the 
cell site itself or at the MSC. A typical cell site is made up 
of the following computer base station equipment, which is 
integrated to form a single functioning component of the 
overall wireless network:
     A cell site controller (CSC), which is a 
specialized computer that connects calls and maintains call 
quality. The CSC controls the computer-based functions of the 
cell site. Specifically, the software in the CSC allows the CSC 
to communicate with both the cell phone and the MSC, and to 
relay and construct the messages that are required to connect 
and disconnect calls. Further, the CSC is responsible for 
monitoring hand-offs and for relaying signal strength 
measurements to the MSC. In addition, the CSC operates together 
with the transmitters, receivers and transceivers that modulate 
the voice signal into a radio frequency, and vice versa. For 
example, when a cell phone makes or receives a call, the CSC 
will instruct one of the transceivers to begin transmitting and 
will send a digital transmission to the cell phone with 
instructions as to the frequency on which the transceiver is 
communicating. Because the CSC is a functional extension of the 
MSC, any upgrade or change to the MSC will require an upgrade 
of the CSC.
     Transmitters, receivers, transceivers, antennas 
and modems that enable the cell site controller to communicate 
with both the MSC and the wireless telephone. The transmitting 
and receiving equipment is controlled and operated by software 
programs that execute on cell site computers, and these 
transform signaling and speech information between the formats 
used in the land-line communications facilities and those used 
in over the air transmissions between the cell site and the 
mobile units.
     Power equipment. A variety of power equipment 
exists to provide the electrical power necessary to keep the 
cell site switching equipment operational under all 
circumstances. For example, this equipment is necessary to 
convert the external power supply for AC to ``controllable'' 
DC; to operate the cell site equipment; to monitor and filter 
the power level; and, as a secondary function, to ensure that 
there is a back-up power supply in the case of a complete 
commercial power failure. This power equipment is peripheral 
equipment that is essential to the operation of all the cell 
site computer-based switching equipment.
     An enclosure to protect the electronic equipment 
and climate control equipment that enables the equipment to 
operate within a controlled temperature and humidity range
    In order for a cell site to operate, each component listed 
above must be present and in working order.

Changes over Time: Smaller, More Integrated, Similar to 
Personal Computers

    The cell site has experienced the same technological 
advancements in terms of size and integration as most other 
technology-based industries. Cell sites are analogous to early 
mainframe computers, which often occupied large amounts of 
space, sometimes entire rooms within office buildings. Each 
successive mainframe required less space, and eventually the 
personal computer (PC) was developed. Today's laptop and 
palmtop PCs weigh as little as a few pounds, but have 
exponentially greater computing capacity than the first room-
sized mainframes.
    Early cell sites, while always an integral component of 
wireless communications, included an antenna, an enclosure and 
computer based switching equipment that required leasing a 
separate sizable piece of real estate to assemble the finished 
product. As wireless equipment continues to evolve, the size of 
cell site equipment is integrated into a smaller package. 
Industry experts predict that future cell sites will fit into a 
small box and will be placed on utility poles and existing 
interstate traffic signs. While functionality and capacity have 
increased, Figure 1 shows how the size of the enclosures has 
decreased.

[GRAPHIC] [TIFF OMITTED] T8411.008


Cell Site Equipment

    Although the next generation of cell site equipment has 
been dubbed 3G (for ``third-generation''), there have already 
been several waves of wireless technology. Table 1 describes 
the major introductions of new cell site equipment that have 
occurred since 1983. The first generation of equipment used 
with AMPS was introduced for commercial use in 1983. This 
analog system was designed to carry one voice channel per 30 
kHz bandwidth. The first digital alternative to AMPS was 
introduced in 1989. This system, called TDMA (``Time Division 
Multiple Access''), allowed more than one user to share the 
same voice channel, effectively tripling the number of calls 
per bandwidth area.
    A different and still more efficient digital encoding 
system called CDMA (``Code Division Multiple Access'') was 
introduced in 1994. CDMA doubled the carrying capacity of TDMA, 
allowing six users to share the same voice channel that 
formerly would have been assigned to one analog user. A third 
digital standard, GSM, has also been developed. CDMA, TDMA, and 
GSM technologies are used for the new all digital cell sites 
operating in the PCS bandwidth, which was assigned by auction 
in 1993 and 1994. Continual technological advancements such as 
CDMA, TDMA, and GSM allow more efficient utilization of 
spectrum and reduce the size of cell site enclosures.

Table 1: Major Technological Changes 1984-1998


------------------------------------------------------------------------
                                                Cell Site
                                Users per 30    Enclosure      Year of
       Type of Equipment             kHz       Dimensions    Commercial
                                  Bandwidth      (feet)          Use
------------------------------------------------------------------------
Analog........................            1   30         1984
                                                      50
Digital.......................            3   20         1990
                                                      40
Digital.......................            6   10         1996
                                                      20
Digital \1\...................            9   34         1998
                                                        
------------------------------------------------------------------------
Source: Ernst & Young


Overview of Federal Depreciation Rules and Current Treatment of 
Wireless Telecommunications Equipment

    The cost of most tangible depreciable property placed in 
service after 1986 is recovered using the modified accelerated 
cost recovery system (MACRS) enacted as part of the Tax Reform 
Act of 1986. Under MACRS, assets are grouped into classes of 
personal property and real property, and each class is assigned 
a recovery period and depreciation method. The applicable 
class-life and method used to compute the annual depreciation 
allowance varies depending upon the particular asset being 
depreciated. An IRS table lists various Asset Classes, along 
with their respective class lives and recovery periods.
    The commercial wireless industry was in its infancy in 1986 
and 1987 when the depreciation system was last revised. As a 
result, the rules which are currently being applied by the IRS 
and by the wireless industry were originally developed without 
specifically considering the characteristics of wireless 
telecommunications equipment.
    The IRS and the wireless industry have taken different 
paths regarding wireless telecommunications equipment \2\ 
depreciation issues since 1986. The IRS approach has been to 
break down cell site equipment into their individual sub-
components and depreciate each based on the functional nature 
of the individual sub-component. Wireless companies have taken 
the position that the functional nature of the integrated 
components should dictate how the assets should be depreciated, 
and that the parts of the cell site cannot operate 
independently and therefore should be considered an integrated 
asset. The differences have resulted in ad hoc, inconsistent, 
and costly case-by-case determinations as the issue has arisen 
on audit.
---------------------------------------------------------------------------
    \2\ See http://www.lucent.com/wirelessnet/products/networks/
cdmahowworks.html for a description of the latest CDMA call densities.
---------------------------------------------------------------------------
    The IRS recently provided limited guidance on the 
application of Rev. Proc. 87-56 to wireless assets in Technical 
Advice Memorandum 98-25-003 (Jan. 30, 1998) (``TAM''). The TAM 
asserted that the classes of assets used to provide wireless 
telecommunications service are comparable to wireline 
telecommunications assets and thus should be assigned to 
wireline asset classes. The IRS based this conclusion on the 
fact that wireless assets performed switching, transmission, 
reception and coordination functions similar to the wireline 
assets. The TAM did conclude that mobile switching centers 
should be classified in asset class 48.121 (computer-based 
telephone central office switching equipment), but it failed to 
take a definitive position with respect to the classification 
of cell site equipment.
    Because the conclusions in the TAM with respect to the 
classification of cell site equipment were not definitive, the 
TAM provides little practical guidance for IRS auditors or 
taxpayers as to the proper classification of cell site 
equipment. Because cell site equipment is the backbone that 
makes wireless telecommunications possible, the failure to have 
clear agreement between the IRS and the industry on the rules 
for depreciating this equipment poses substantial difficulties 
for the industry.

Significant Increase in the Cost of Capital

    As previously noted, the IRS's approach during audits has 
been to break cell site equipment down into its sub-components 
and propose depreciating each sub-component on its alleged 
functional nature, often using a 10-year recovery period (which 
equates to a 16 to 20 year class life). The assignment of 
assets that are properly five-year property to improper 
depreciation classes with longer recovery periods has a large 
impact on the cost of investment borne by wireless companies. 
Table 2 shows the effect on the hurdle rate of return \3\ and 
the effective tax rate of improper assignment of five-year 
property to classes with longer recovery periods.\4\ The pre-
tax hurdle rate of return when the assets are properly assigned 
is 19.1 percent, while the effective tax rate on the assets is 
close to the statutory rate of 35 percent.\5\
---------------------------------------------------------------------------
    \3\ The hurdle rate of return is defined to be the pre-tax internal 
rate of return a project must exceed before it would be profitable for 
a company to undertake it.
    \4\ The hurdle rate of return is defined to be the pre-tax internal 
rate of return a project must exceed before it would be profitable for 
a company to undertake it.
    \5\ The calculations assume an inflation rate of 3.3 percent, 100 
percent equity financing and a pre-individual income tax discount rate 
of 12.2 percent. Economic depreciation is assumed to follow 150 percent 
declining balance. The corporation is assumed to be a non-AMT taxpayer 
with a 35 percent marginal income tax rate. Depreciation allowances are 
computed using the 200 percent declining balance schedule for 5 and 7-
year assessments and the 150 percent declining balance schedule for 10 
and 15-year assessments.
---------------------------------------------------------------------------

Table 2: Hurdle Rates of Return and Effective Tax Rates for Cell Site 
Equipment


------------------------------------------------------------------------
                                                      Hurdle
             Assigned Recovery Period                Rate of   Effective
                                                      Return    Tax Rate
------------------------------------------------------------------------
5 years...........................................     19.2%      35.0%
7 years...........................................     22.5%      44.4%
10 years..........................................     26.9%      53.2%
15 years..........................................     36.2%      64.4%
------------------------------------------------------------------------
Source: Ernst & Young

    When the five-year property is not properly assigned, the 
hurdle rates of return increase. If the assets are classified 
as 15-year property, the hurdle rate of return almost doubles, 
rising to 36.2 percent, while effective tax rate rises to over 
64 percent. The result of misclassifications is to impose 
unfairly high taxes on wireless companies, compared to other 
companies utilizing assets that have properly defined class 
lives. The burden of these unfair taxes is borne by the users 
of wireless service, who pay a hidden tax, and potential users 
of wireless systems who do not receive service due to decreased 
investment and slower build-out.
    One of the guiding principles of MACRS is that the 
depreciation tax life of an asset should be shorter than the 
actual book life of the asset (i.e., ``accelerated''). The 
median five-year recovery period used by companies filing their 
tax returns is more consistent with the principles underlying 
MACRS as to the rapid obsolescence of wireless equipment. Given 
the rapid technological change and advances in the wireless 
industry, the median five-year recovery period used by many 
companies on their tax returns is the maximum recovery period 
that should be applied given the rapid obsolescence of wireless 
equipment. Clearly, the appropriate class life of wireless 
telecommunication assets does not even approach 10 years, let 
alone the 16 years to 20 years used by the IRS.
    In addition to imposing higher capital costs, the lack of 
clarity in the depreciation rules for cell site equipment 
places wireless companies at a significant risk of incurring 
penalties and interest as a result of depreciation audit 
adjustments. This is particularly troublesome given the 
industry's merger and acquisition activity. Acquiring companies 
are finding that some acquired companies may have significant 
exposure on audit as a result of depreciation elections made in 
past years.

Solution -Include Wireless Equipment in Qualified Technological 
Equipment

    Rather than trying to shoehorn wireless telecommunications 
equipment into wireline telephony ``transmission'' or 
``distribution'' classes, a better solution would be to include 
wireless telecommunications equipment within the definition of 
``qualified technological equipment,'' which the Code currently 
defines (in section 168(i)(2)) as any computer or peripheral 
equipment, any high technology telephone station equipment 
installed on a customer's premises, and any high technology 
medical equipment. The wireless telecommunications industry 
believes that its equipment is properly characterized as 
``qualified technological equipment'' because of the fact that 
the major components of wireless networks are in fact computers 
or peripheral equipment controlled by computers.
    Qualified technological equipment has a five-year 
depreciable life under the current depreciation system. Given 
the rapid technological changes that are expected to continue 
in the wireless industry, a depreciable life of anything 
greater than five years will penalize this fast growing 
industry and limit the capital available for the build out of 
an advanced wireless network that will benefit consumers, 
businesses and the U.S. economy.
    Representative Phil Crane (R-IL) will be introducing 
legislation this week to make this important clarification. We 
are grateful to Representative Crane for recognizing the need 
to address this problem and provide certainty to the wireless 
telecommunications industry and its customers.

Summary

     Depreciation guidance for the wireless industry is 
needed to provide certainty and avoid further controversy 
leading to unnecessary costs to both the government and 
industry.
     The current depreciation system should be revised 
to clarify that all wireless telecommunications equipment is 
included in the ``qualified technological equipment'' category. 
Additionally, Congress should carefully consider the need for 
reducing the five-year recovery period to provide proper 
recognition of the economic life and resultant class-life for 
wireless equipment.
    To ensure depreciation certainty in the future, Congress 
should recognize the rapid technological change occurring in 
the information age and be prepared to shorten depreciable 
lives for assets that increasingly have shorter economic useful 
lives. Corrective action would assist the IRS in performing 
simplified, accurate audits and would greatly reduce the high 
compliance costs and excessive capital costs currently borne by 
wireless companies. Clarification of the depreciation rules 
will allow wireless companies to continue to pursue business 
objectives which translate into continued job growth, 
productivity gains, and overall economic expansion.
      

                                


    Chairman Houghton. Thanks very much, Ms. Feldman.
    Mr. Jernigan?

STATEMENT OF CLIFFORD JERNIGAN, DIRECTOR, WORLDWIDE GOVERNMENT 
  AFFAIRS, ADVANCED MICRO DEVICES, ON BEHALF OF SEMICONDUCTOR 
          INDUSTRY ASSOCIATION, SUNNYVALE, CALIFORNIA

    Mr. Jernigan. Thank you, Mr. Chairman and members of the 
committee. My name is Cliff Jernigan, and I am director of 
worldwide government affairs at AMD. I am testifying today on 
behalf of the Semiconductor Industry Association, which 
represents a $77 billion American semiconductor industry.
    It's been 7 years since I last testified before this 
committee on depreciation reform. In the meantime, many U.S. 
companies in our industry have set up plants overseas at the 
expense of American sites, and I think that's unfortunate. This 
afternoon, I would like to do three things: first, I would like 
to describe our industry and the market in which we compete. 
Secondly, I will explain why the current tax depreciation rules 
for semiconductor manufacturing equipment are outdated and 
discourage investment; and third, I will urge the committee to 
support H.R. 1092, the Semiconductor Equipment Investment Act 
of 2000, sponsored by Representatives Johnson and Matsui, which 
reduces the tax depreciation period for the equipment we use to 
make chips from 5 to 3 years.
    Let me begin by describing our industry. The semiconductor 
industry is now America's largest manufacturing industry in 
terms of economic value added, contributing 20 percent more to 
the U.S. economy than the next leading industry. We employ 
about 280,000 people in high-paying jobs. Parenthetically, our 
employment level was about 280,000 people in 1985. Our 
employment has remained constant in the United States, but it 
has increased overseas, and that's a result of more of our 
plants being located overseas.
    Driving the growth of the semiconductor industry is the 
ever-shrinking transistor, the basic building block of a 
semiconductor chip. A decade ago, we were able to integrate 
thousands of transistors on a single silicon chip. Today, we 
can integrate millions of transistors on a single chip, and 
tomorrow, we expect to be able to integrate billions of 
transistors on a single chip.
    To remain competitive in this rapidly changing environment, 
U.S. chipmakers invest 30 cents out of every dollar of sales 
into R&D and capital equipment. Unfortunately, the current tax 
code fails to recognize the rapid pace of change in our 
industry in that it requires an unreasonably long period, 5 
years, to recover the cost of our equipment, and I submit 
that's one reason many of our companies are being forced to 
move overseas.
    The useful life of semiconductor manufacturing equipment is 
3 years, not 5; probably even less than 3 today. There are 
several economic studies cited in my written testimony that 
demonstrate this point. Rather than review these studies now, 
let me just note what anyone who has shopped for a home 
computer already knows--thank you, Congressman Weller--and that 
is that every few months, new models are available that are 
faster and have more memory for the same price.
    This is because the chips in these computers continue to 
grow more complex; that is, they perform more functions at 
faster and faster speeds. It takes new and more complex 
equipment to manufacture each generation of chips, and so, we 
have to continually replace our equipment.
    The outdated depreciation laws penalize the U.S. 
semiconductor industry. Furthermore, they also discourage 
investment in the U.S. at a time when other nations are doing 
all they can to attract semiconductor industry investment in 
plants that cost today between $2 billion to $3 billion each. 
Japan, Korea, Taiwan, and many countries in Europe all provide 
more favorable depreciation rates, and in some cases, cash 
grants or tax holidays to encourage investment.
    You may have read yesterday's Wall Street Journal article 
about countries trying to entice high-tech companies by 
offering significant incentives. I would like to include this 
article as part of my written testimony, and I know that you 
have a copy now in your possessions.
    SIA estimates that an American community seeking to attract 
a multibillion dollar chip plant faces a significant handicap 
due to the U.S. depreciation laws even before the chipmaker 
considers other factors such as workforce and infrastructure 
costs. In recognition of these issues, Representatives Nancy 
Johnson and Bob Matsui have introduced H.R. 1092 to shorten the 
depreciation period for semiconductor manufacturing equipment 
to 3 years. There are currently 47 other cosponsors of this 
bill, including 10 members of the Ways and Means Committee and 
four members of this Subcommittee.
    I would like to take this opportunity to thank Chairman 
Houghton and Representatives Dunn, Neal and McNulty for 
cosponsoring this legislation. I would also like to note that 
this issue enjoys bipartisan support and has been endorsed by 
both the Republican Main Street Partnership and the Progressive 
Policy Institute.
    Interestingly, shorter depreciation was part of President 
Clinton's platform in 1992, and it was part of Bob Dole's 
platform in 1996, but we can't seem to get it done. It is 
important for us to move quickly to pass this bill. The 
semiconductor industry is undergoing a once-in-a-decade change 
in wafer size, moving from manufacturing chips on an eight-inch 
diameter wafer to 12-inch wafers. This shift increases the area 
of the wafer, allowing manufacturers to produce more chips per 
wafer and thereby greatly reducing costs.
    But first, this shift will require an investment in plant 
and manufacturing equipment probably in the range of $3 billion 
to $4 billion. I appreciate the desire of many in Congress to 
undertake comprehensive depreciation reform. However, this 
could be months if not years. It took 2 years to do the 
Treasury study, and we still aren't there yet with solutions. 
However, technological change in the new economy moves at 
lightning speed, and while a comprehensive reform effort is 
underway, 12-inch wafer plants that might have been built in 
the U.S. will instead be built overseas.
    Therefore, I urge Congress to pass H.R. 1092, not next year 
but this year.
    In closing, let me leave you with this thought: as you 
consider changes to the tax code to reflect the new economy, 
remember that the Internet is, in fact, a World Wide Web of 
silicon chips. I urge you to shorten the depreciation life for 
equipment used to make these chips and that will make the 
Internet possible. Thank you for your attention to this issue, 
and I look forward to answering any questions you may have.
    [The prepared statement follows:]

Statement of Clifford Jernigan, Director, Worldwide Government Affairs, 
Advanced Micro Devices, on behalf of Semiconductor Industry 
Association, Sunnyvale, California

    Thank you Chairman Houghton.
    My name is Clifford Jernigan and I am the Director of 
Worldwide Government Affairs for AMD. I am testifying today on 
behalf of the Semiconductor Industry Association (SIA), which 
represents the $77 billion American semiconductor industry. The 
SIA is pleased to have this opportunity to testify before the 
Oversight Subcommittee of the Committee on Ways and Means on 
the need to reform our tax cost recovery rules for the New 
Economy.

    This afternoon I would like to

    1. describe our industry and the market in which we 
compete;
    2. explain why the current tax depreciation rules for 
semiconductor manufacturing equipment are outdated and 
discourage investment; and
    3. urge the committee's support for the Semiconductor 
Equipment Investment Act of 2000, which reduces the tax 
depreciation period for semiconductor manufacturing equipment 
from five years to three years.

Semiconductors Drive Today's Information Age

    The semiconductor industry is now America's largest 
manufacturing industry in terms of economic value-added -we 
contribute 20 percent more to the U.S. economy than the next 
leading industry. The industry employs 284,000 people in the 
United States, and these are high paying jobs with wages 
significantly above average at every level.
    Propelling the growth of the semiconductor industry is the 
ever-shrinking transistor--the basic building block of a 
semiconductor chip. A decade ago, we integrated thousands of 
transistors on a single silicon chip. Today we integrate 
millions of transistors on a single silicon chip. The 
implications of this technological progress cannot be 
overstated. The Internet is, in fact, a world wide web of 
silicon chips.
    Semiconductor technology advances improve productivity 
throughout our economy, leading to the low unemployment and low 
inflation we enjoy today. Federal Reserve Chairman Alan 
Greenspan, discussing the structural changes behind the current 
economic expansion, stated ``. . .the development of the 
transistor after World War II appears in retrospect to have 
initiated a special wave of creative synergies. It brought us 
the microprocessor, the computer, satellites, and the joining 
of laser and fiber optic technologies. . . It is the 
proliferation of information technology throughout the economy 
that makes the current period appear so different from 
preceding decades.'' (Remarks before the 92nd Annual Meeting of 
the National Governor's Association, July 11, 2000).
    The pace of innovation in the semiconductor industry is 
among the fastest of any U.S. or worldwide industry. To remain 
competitive in this rapidly changing environment, U.S. 
chipmakers invested $11 billion in R&D and $17 billion in 
capital equipment in 1999. The next generation of fabrication 
facilities, those capable of processing 300mm wafers, will cost 
between $2-3 billion each. Chip manufacturing equipment will 
account for about 85 percent of the cost of these new 
facilities.
    Competition in this environment is fierce. The U.S. lost 
its worldwide market share lead to Japan in 1986, but fought 
hard to come back. And comeback we did, increasing from 37 
percent global market share a decade ago to 50 percent market 
share today.
    Since the pace of technological change is extremely rapid 
in our industry, SIA member companies spend a greater 
percentage of sales on R&D and capital equipment than any other 
industry. In fact, over a third of the industry's revenues last 
year were plowed back into R&D and capital equipment 
investments. Despite this, U.S. semiconductor manufacturers 
labor under an inequitable situation. Although the economic 
life of semiconductor manufacturing equipment is three years, 
the industry is penalized under current tax law, which requires 
a five year cost recovery. That is why we are here today.

The Current Depreciation Life is Too Long

    There are three commonly cited methods for estimating the 
useful life of assets like semiconductor manufacturing 
equipment. These three methods are the income approach (which 
recognizes a decline in an asset's value based on the asset's 
diminishing ability to generate income), the cost approach 
(which bases the value of each used asset on the cost of 
replacing it with a new asset, but with consideration given for 
the reduced remaining service life of the used asset), and the 
market approach (which bases relative value on the proceeds of 
recent relevant sales of manufacturing equipment as a 
percentage of the original cost of each asset). Each of these 
three approaches recognizes that the equipment can continue to 
be used after technological obsolescence, but only for the 
manufacture of older, lower cost, lower value-added products. 
The SIA-sponsored American Appraisal Associates study conducted 
in 1991 used the market approach, and concluded that the 
economic life of semiconductor manufacturing equipment was 
about 3.75 years. A 1995 study by Lane Westly used the income 
approach and found that semiconductor manufacturing equipment 
had a useful life of only 3.27 years. The Lane Westly study 
also found that a cost approach provided results consistent 
with the income approach. Both studies clearly support the 
conclusion that semiconductor manufacturing equipment should be 
depreciated over three years rather than five.
    There is further evidence suggesting that the pace of 
technological obsolescence has quickened since the American 
Appraisal and Lane Westly studies. Since 1988, the SIA has been 
issuing technology roadmaps to identify and forge a consensus 
as to the key challenges to increasing chip productivity, and 
to focus research on overcoming those challenges. The roadmap 
is developed by semiconductor experts from the U.S., Japan, 
Europe, Korea, and Taiwan, and identifies key challenges to 
staying on our historical productivity trend. The 1998 roadmap 
found that the industry has actually ``skipped'' a year 
compared to the roadmap that had originally been projected. For 
example, the 1997 roadmap projected that the 1 Gigabit memory 
chip would be introduced in 1999 rather than in 2001 as 
projected in the prior roadmap. The 1998 roadmap projects the 4 
Gigabit will be introduced in 2002, a year earlier than 
projected in the 1997 roadmap. (See http://notes.sematech.org/
ntrs/ PublNTRS.nsf for more details on the roadmap).
    Technological change not only makes semiconductor 
manufacturing equipment obsolete, but it makes the statutory 
depreciation class lives obsolete as well.

U.S. Depreciation Laws Penalize U.S. Companies and Discourage 
Investment in the U.S.

    Other nations are working to encourage investments in 
semiconductor production. Japanese law allows for recovery of 
up to 88 percent of the cost of chip equipment in the first 
year alone; Korea depreciates the equipment over four years 
with special benefits that permit additional accelerated 
methods or write-downs. Taiwan allows three year straight line 
depreciation, but more importantly, also grants tax holidays 
that make the depreciation rate a moot point. Singapore also 
grants tax holidays for new semiconductor factories. Some 
European countries, such as Germany and Italy, have actually 
financed a significant part of semiconductor plants through 
cash grants and below market interest rates. By contrast, 
current U.S. tax law actually discourages investment in U.S. 
semiconductor plants.
    Current U.S. tax law not only puts our semiconductor makers 
at a severe disadvantage with respect to their foreign 
competitors, it also makes the U.S. a less attractive 
investment location for the new, multibillion dollar 
manufacturing facilities the industry will be constructing in 
the next few years. SIA estimates that a State in this country 
seeking to attract a $2.5 billion chip plant faces a $45 
million handicap owing to U.S. cost recovery rules even before 
the chip maker considers other factors such as workforce and 
infrastructure. (The $45 million represents a Net Present Value 
of the imputed interest earned on the difference in the cash 
flow resulting from a five year depreciation schedule rather 
than three year.) The National Advisory Committee on 
Semiconductors, established by Congress in 1988 and composed of 
Presidential appointees, found in 1992 that ``Allowing 
depreciation of equipment over 3 years -a period closer to the 
realistic life for many types of equipment than the current 5 
year allowable life -would increase the annual rate of 
semiconductor capital investment (in the U.S.) by 11 percent.''
    U.S. semiconductor makers seek to have the tax code reflect 
the true useful lives of our assets. The disincentive to invest 
in the U.S. should be removed.

There is an Urgent Need to Fix the Depreciation Problem

    The semiconductor industry is undergoing a once in a decade 
change in wafer size, moving from manufacturing chips on 200 mm 
(8'') diameter wafers to 300 mm (12'') wafers. This shift 
increases the area of the wafer by 2.25 times -from the size of 
a salad platter to the size of a medium pizza -allowing 
manufacturers to produce more chips per wafer, thereby greatly 
reducing costs.
    The move to 300mm wafers is but one of the current 
technology shifts in the semiconductor industry. Jay Deahna, 
Semiconductor Capital Equipment Analyst at Morgan Stanley Dean 
Witter, has written that:
    ``While semiconductor companies bought tools [in 1998] to 
maximize the output of their existing fabs this year, next year 
new clean rooms will be populated with entirely new sets of 
tools, which is positive for equipment company growth. Average 
order size should get larger, lead times may stretch, and 
pricing may increase. . .
    ``In the next 5-10 years, we expect more chip manufacturing 
changes than the previous forty years. This will be driven by 
new materials (copper, low k oxides, 300 mm), equipment 
(scanner, electroplating, 300 mm, full-fab automation, PSM 
masks), and manufacturing techniques (sub-wavelength 
lithography, Damascene). ''  [emphasis added. From Jay Deahna, 
``Semiconductor Equipment Forecast'' in November 1999 
newsletter, ``What's Up From SEMI'']
    Recognizing the rapid technological obsolescence in the 
semiconductor industry, Representatives Nancy Johnson (R-CT) 
and Bob Matsui (D-CA) have introduced The Semiconductor 
Equipment Investment Act (H.R. 1092) to shorten the 
depreciation period for such equipment to three years. There 
are currently 47 other cosponsors on this bill, including ten 
members of the Ways and Means Committee and four members of 
this subcommittees, including you, Mr. Chairman. Thank you.
    I appreciate the desire of many in Congress to establish a 
process for comprehensive depreciation reform, including 
further studies on specific industries. However, technological 
change in the New Economy occurs at lightning speed. The SIA is 
concerned that while such a process is underway, 300mm wafer 
plants that might have been built in the U.S. will instead be 
built overseas. Therefore, we urge the Congress to pass H.R. 
1092, the Semiconductor Equipment Investment Act of 2000.

Conclusion

    U.S. depreciation schedules should reflect the true 
economic life of semiconductor manufacturing equipment. By not 
reflecting technological obsolescence, U.S. tax law puts this 
dynamic industry at a disadvantage vis-à-vis its foreign 
competitors and helps drive investment offshore.

    SIA respectfully requests that the Congress:

    1. recognize that the economic life of semiconductor 
manufacturing equipment is three years, not five; note the 
urgency for semiconductor depreciation reform created by 
technological shifts such as the move to 300mm wafers; and pass 
the Semiconductor Equipment Investment Act of 2000 this year.

    Thank you for your attention to this issue.
      

                                


    Chairman Houghton. Thank you very much, Mr. Jernigan.
    Mr. Vogel?

 STATEMENT OF THEODORE VOGEL, VICE PRESIDENT, TAX COUNSEL, DTE 
    ENERGY COMPANY, ON BEHALF OF EDISON ELECTRIC INSTITUTE, 
                       DETROIT, MICHIGAN

    Mr. Vogel. Good afternoon, Mr. Chairman, Mr. Coyne, members 
of the subcommittee. My name is Ted Vogel, and I'm vice-
president and tax counsel for DTE Energy Company, the parent 
company of Detroit Edison, which is an electric utility serving 
Southeastern Michigan.
    I'm currently the chair of the Edison Electric Institute 
taxation committee, and I'm testifying here on its behalf. I've 
previously filed a written statement with the committee. I'd 
like to just highlight some items that are in that statement. 
Let me initially note that we are an industry that has most of 
its assets classified as 20-year property for Federal tax 
purpose--long depreciation lives--and traditionally viewed as 
long-lived assets.
    There are several major developments that have been going 
on in the last few years in our industry that I think you 
should be aware of that I think is changing that perception of 
our industry and our assets.
    First of all, as you are aware, we had a crisis in electric 
energy supply this summer. I'll touch on that point. Secondly, 
the electric utility industry is being restructured in a way 
that has eliminated the traditional vertical monopoly and 
replaced it with a competitive marketplace. And thirdly, we're 
seeing an increased pace of technological change in the 
industry that brings about quicker economic obsolescence of 
assets.
    In addition, there are some disparities in the existing tax 
treatment of our assets that we'd like to call to your 
attention. In short, we think the answer is to shorten these 
long--very long--depreciable lives. In particular, we're 
supporting H.R. 4959, which would shorten depreciable lives of 
electric generating equipment from the 15 and 20 year lives 
that they have today to 7 years.
    As to the first point, as you're aware, in the California 
market this summer, there were severe electricity supply 
crises: San Diego, San Francisco, Silicon Valley, all suffered 
brownouts, power spikes and other energy shortages. This was 
directly as a result of insufficient generating capacity in 
California and an inability to import enough power into the 
State. In particular, Silicon Valley firms suffered some 
losses. The Hewlett Packard energy manager indicated that if 
they lost one day's worth of power, it would amount to $75 
million of lost revenue.
    California is not alone. We're seeing alarming projections 
for much of the country as well in terms of the future growth 
of power. In fact, a J.P. Morgan study just released this month 
now projects 5 percent or more in annual growth rates. Where is 
this growth coming from? It's coming from information 
technology, computers, Internet; the growth of our society in 
information and in telecommunications, all of it powered by 
electricity.
    We believe that Congress should act now and should in fact 
shorten depreciation lives, and remove the disincentive to 
build power plants. Currently, the long depreciation lives for 
power plants creates a capital disincentive, and it makes it 
harder to attract the needed capital for growth.
    The second major development in our industry is the 
electrical industry restructuring that's taking place all over 
the country. Most States now have moved toward deregulating 
their markets. Traditionally, the electrical utility industry 
was vertically integrated. You had regional monopolies that 
were regulated by the local or State public service 
commissions. In fact, the commissions' incentive was to stretch 
out depreciation lives as long as possible to keep rates low. 
As a result, utilities had no incentives to retire assets early 
and upgrade their systems for technological improvements until 
they had recovered their costs.
    With an open, competitive marketplace, that's no longer the 
case. Recovery is no longer based on cost; it's going to be 
based on technological innovation.
    And that brings me to the third point: technological 
innovation is happening in our industry. A generation ago, most 
power plant were coal-fired, nuclear-fired, large power plants 
that, quite frankly, the technology moved fairly slowly on. If 
you built a plant, you knew it could pretty much operate for 40 
years with very little change.
    In the last decade alone, we've seen an enormous shift as 
new generation has moved to gas-fired turbine combined-cycle 
operations. These turbines were only 40 to 50 percent efficient 
a mere decade ago. Today, they're approaching 70 percent 
efficiency. That is driving increased economic obsolescence for 
power plants much quicker than we have seen in the past.
    Other areas of technological developments are coming fast 
down the pike: distributed generation, fuel cells, 
microturbines; a lot of developments that I think we're going 
to continue to see in the future that will continue to bring 
about quicker obsolescence than this industry has experienced 
in the past.
    Finally, there are some inequities in the current 
depreciation system. For example, most of other industries have 
much faster depreciation lives than ours. Paper mills, steel 
mills, lumber mills, foundries, those types of facilities, 
manufacturing plants, have seven-year lives, even though their 
assets are very similar to power plants in terms of the overall 
useful life of those assets. Chemical plants can be depreciated 
in a mere five years.
    And again, a lot of that historic disparity came out of the 
rate-regulated environment and the monopoly environment that 
once existed in our industry. It is now changing.
    Other anomalies: a turbine generator owned by a 
manufacturer producing power in exactly the same way as one 
owned by a utility will receive a shorter depreciation life 
under the tax code. A process control computer on, for example, 
a cigarette plant will receive a 7-year life, whereas a process 
control computer operating a generating plant is given a 20-
year life. So, these kinds of disparities are there in the 
code. Some of them are addressed in the Treasury report, and we 
appreciate that, and we think those need to be rectified.
    In conclusion, we appreciate the Treasury report. There is 
some good discussion on page 97 about the challenges facing the 
industry, about the changes that are occurring in the industry 
and the need to address depreciation rates in the industry, and 
we heartily endorse that conclusion. We would like to thank 
committee members Thomas, Jefferson and English for their 
leadership in sponsoring H.R. 4959.
    Thank you for the opportunity to participate.
    [The prepared statement follows:]

Statement of Theodore Vogel, Vice President, Tax Counsel, DTE Energy 
Company, on behalf of Edison Electric Institute, Detroit, Michigan

    My name is Ted Vogel and I am the Vice President and Tax 
Counsel for DTE Energy Company, the parent holding company of 
Detroit Edison Company. Detroit Edison is an integrated 
electric utility serving greater southeastern Michigan with 
non-regulated subsidiaries active throughout the United States. 
DTE has 2.1 million customers, generates and sells over 50 
million MWH of electric energy per year, has approximately 
9,000 employees and annual revenues in excess of $4.7 billion. 
I am responsible for tax planning and tax compliance for DTE 
Energy. I am testifying today on behalf of the Edison Electric 
Institute (EEI), specifically the energy supply division of 
EEI, the Alliance of Energy Suppliers. Ron Clements, Director 
of Governmental Relations at EEI, is accompanying me today.
    EEI, through its Alliance of Energy Suppliers, serves the 
needs and advances the commercial interests of power producers 
and power marketers throughout the United States by advancing 
public policy positions that enhance the competitiveness and 
effectiveness of the regulated and unregulated producers, 
distributors and sellers of electric energy.

                      THE CRISIS IN ENERGY SUPPLY

    The recent headlines that describe the energy supply crisis 
in the San Diego region of southern California are a vivid 
example of the need to construct additional generation and 
transmission capacity in many areas of the United States. 
Responding to market demand, almost 52,000 megawatts of 
merchant generation--that is, unregulated generating plants 
selling energy for resale, not to end-use customers--are 
scheduled to come on-line by the end of 2001. This increase in 
generating capacity comes far too late, however, to provide 
relief from the situation caused by current shortfalls in 
generating and transmission capacity.
    The San Francisco Bay area also experienced several 
blackouts this summer as a result of insufficient generating 
capacity in, or availability for import into, the State of 
California. Not only was in-state generation in too short of 
supply, but, even worse, the California Independent System 
Operator, the quasi-public operator of the transmission grid in 
California, could not import enough power from neighboring 
States to fuel California's high demand for electricity. 
Rolling blackouts were instituted in the San Francisco Bay area 
on June 14 this summer. Many employees at Silicon Valley 
technology companies like Hewlett Packard worked in near 
darkness with limited air conditioning. Hewlett Packard's 
energy manager told Dow Jones News Service that a blackout in 
Silicon Valley would cost companies there as much as $75 
million dollars a day in lost revenues.\1\
---------------------------------------------------------------------------
    \1\ Dow Jones News Wire, September 20, 2000.
---------------------------------------------------------------------------
    The investment firm, J.P. Morgan, reported earlier this 
month that U.S. demand for electricity is likely to grow at 
more than 5 percent a year, driven largely by the spread of 
information technology and telecommunications infrastructure. 
Information technology and telecommunications presently account 
for 16 percent of U.S. energy consumption, according to the 
report.

                   CONGRESSIONAL ACTION IS NEEDED NOW

    Energy shortages have been severe across California, as the 
State's expanding economy has out-stripped the construction of 
new power plants. To quote President Clinton,\2\ ``The 
wholesale price of electricity has risen sharply in California 
this summer as a result of tight supplies and growing demand.
---------------------------------------------------------------------------
    \2\ Power Marketing Association, Online Daily Power Report, August 
23, 2000
---------------------------------------------------------------------------
    This is having a particularly heavy impact where the price 
hikes are being passed on to consumers, as they are in the San 
Diego region.'' The President released $2.6 million in 
emergency funds for low-income families to cope with higher 
energy costs. He also directed the Small Business 
Administration to set up a program for small businesses to 
apply for loans to pay their electricity bills. Acknowledging 
California's ``power-crunch,'' he renewed his calls to Congress 
to take up his Energy Budget initiatives and tax incentives.
    The explosive growth in electronic equipment, computers, 
telecommunications, and bandwidth content has produced a 
dramatic increase in the demand for electricity. All elements 
of this new energy intensive information-based economy have two 
things in common. All the equipment and content utilized in 
this trend incorporate silicon-based microprocessors and 
electricity. Everything is plugged in to an electrical outlet. 
Personal computers and servers are nothing more than electron 
conversion devices that accept kilowatts though a power source 
and convert, create, store, and transmit those kilowatts into 
digital bits of information. This new information economy is 
powered exclusively by electricity. The Internet is becoming 
more electricity intensive. Wireless Internet and 
telecommunications applications are growing at an even faster 
rate than basic Internet growth.
    Congress must act now. The most efficient manner for 
Congress to act is to legislate incentives to encourage the 
construction of new or more efficient electric generation 
facilities. The demand for power in this country is staggering 
and, with 16 percent of all electric energy being used to 
support e-commerce and computers generally, annual growth is 
outstripping new capacity by an alarming rate. The inability to 
provide sufficient generating capacity will have dire impacts 
for virtually all sectors of the country's economy.

               IMPACT OF ELECTRICY INDUSTRY RESTRUCTURING

    Until the mid-1990's, the investor-owned electric industry 
was composed entirely of single State or regional companies 
that were closely regulated by the various State public utility 
commissions. Companies were vertically integrated: they 
generated power, transmitted the power across their regions and 
then distributed the power to each customer. The companies 
operated as highly regulated monopolies and had an obligation 
to serve all customers.
    In this regulated market, utilities were given an 
opportunity by regulators to recover their investment much 
differently than companies that operate in a more competitive 
marketplace. A regulated company had little incentive to retire 
its assets before the end of their useful life in order to 
deploy new technology. To have done so may have resulted in 
increased costs to customers that would have been unpalatable 
to State commissions and, therefore, not recoverable in rates 
paid for regulated services. This regulated status explains, in 
part, why electric assets have historically had such long 
recovery periods. This no longer is the state of the industry 
today.
    Nationwide, the structure of the electric industry is 
rapidly changing from vertically-integrated, regulated 
monopolies to unbundled and fully competitive generation 
services. Currently, 24 States and the District of Columbia, 
encompassing some 70 percent of the Nation's population, have 
either passed electric industry restructuring legislation or 
enacted regulatory orders to implement unbundling and 
competitive customer choice. In these States, this choice in 
electric generating service supplier is either currently 
available, awaiting a phase-in implementation or part of a 
``big-bang'' implementation in which all customers have the 
choice of electric energy supplier all at once. Because of the 
introduction of competition, previously applicable rules 
regarding the cost recovery of capital simply do not apply any 
longer.
    There also is no regulatory certainty in a deregulated 
electricity market. This is one of the clear contributing 
factors at play in the San Diego situation described above. 
Uncertainty has stifled the interest of competitive generators 
to build new plants. In a regulated environment, predictable 
dividend payments to utility investors permitted them the 
opportunity to earn a return commensurate with the return they 
would earn in industries with similar risk profiles. In a newly 
competitive electricity environment, however, investors will 
demand a return of, and a higher return on, their investments 
over a much shorter period of time to reflect the vastly 
increased risks of an unregulated environment. Shorter capital 
recovery periods are a key element in attracting these 
investors.
    The electric industry is one of the most capital-intensive 
industries in this country, requiring nearly four dollars in 
investment for each dollar of annual revenue. Cost recovery, 
including the Federal income tax rules providing for 
depreciation and amortization of assets, is of vital 
importance. The present 15-20 year depreciation requirement for 
generating assets discourages badly needed investment in the 
construction of new electric generation facilities and in the 
repowering of currently mothballed facilities.

   NEW TECHNOLOGY REQUIRES IMPROVED AND ADDITIONAL CAPITAL INVESTMENT

    Energy producers must build and maintain state-of-the-art 
equipment to accommodate our nation's new technology. 
Competitive pressures that arise through the unbundling of 
retail electric service requires that all competitors be as 
efficient as possible. Because the competitiveness of wholesale 
markets is now an established feature of the industry's 
business landscape, sales for resale must also be generated as 
cost-effectively as possible. The advances in technology 
require that all new construction be more efficient in terms of 
the engineering measurements than equipment manufactured just a 
few years ago. These measurements include capacity factor, heat 
rate and availability factor. New combined cycle gas turbine 
generators are much more efficient today, resulting in more 
rapid obsolescence of older less efficient generating 
equipment.
    Many of the power plants constructed a generation ago were 
coal-fired or nuclear. Power plants being built today are much 
more likely to be gas turbine facilities, often operated in a 
combined-cycle or as cogeneration facilities that produce steam 
for industrial process use as well as electricity. Gas-fired 
turbine technology has made stunning advances over the last 
decade. These new combined-cycle generators operate at energy 
conversion efficiency levels of 70 percent compared to 40-50 
percent only a decade ago. Energy conversion efficiency 
measures the efficiency with which one type of fuel is 
converted to electric energy, which, in turn, is capable of 
providing the light, heat or work that consumers expect. As 
these advances continue, electric generation equipment suffers 
much quicker economic obsolescence than in prior decades when 
the current depreciation rates were set.
    In addition to new generation facilities, existing electric 
generation facilities require massive amounts of investment in 
order to retrofit these facilities and bring them into 
compliance with environmental regulations. The Clean Air Act 
Amendments, new source review, the National Ambient Air Quality 
Standards, and the related State implementation plans all 
require significant new capital investment in environmental 
mitigation technologies in order to improve air quality and 
maintain compliance with Federal and State directives. Again, 
this advanced technology supports the need for shorter capital 
recovery periods.

              THE INEQUITIES OF CURRENT DEPRECIATION RULES

    The recovery periods permitted under section 168 of the 
Internal Revenue Code for assets used to produce and distribute 
electricity are much longer than the recovery periods allowed 
to other capital intensive industries. As in every other 
instance of a heavily regulated industry undergoing 
deregulation, new technology is being developed and deployed at 
a much more rapid pace and makes obsolete many prior 
investments in property, plant and equipment. With most of our 
industry's assets placed in the 15-year and 20-year recovery 
period, the present cost recovery system unjustly penalizes 
investors in electric generation and makes raising necessary 
capital much more difficult.
    The disparity between electric industry recovery periods 
and the recovery periods of other industries is highlighted 
upon review of asset class 00.4, Industrial Steam and Electric 
Generation and/or Distribution Systems. This asset class 
includes equipment identical to that used by the electric 
industry except that the energy generated is used in industrial 
manufacturing processes instead of being sold to others. This 
asset class is given a 15-year life. The same asset in the 
hands of an electric company has a 20-year life. No rationale 
reasonably supports this distinction.
    By contrast to the 15-20 year depreciation lives for 
electric generation assets, depreciation lives for other 
capital intensive manufacturing processes--such as pulp and 
paper mills, steel mills, lumber mills, foundries, automobile 
plants and shipbuilding facilities--are depreciable for Federal 
income tax purposes over just 7 years. Chemical plants and 
facilities for the manufacture of electronic components and 
semiconductors can be depreciated over only 5 years. The power 
plants that generate electricity have useful lives that are 
similar to this production equipment that have recovery periods 
in the 7-year range.
    Another area of concern are the restrictions contained in 
the description of class life 00.12, Information Systems, that 
further compounds the disadvantage suffered by investors in 
electricity generation, transmission and distribution 
facilities. The description excludes computers that are an 
integral part of other capital equipment, thus, giving 
computers used in a power plant control room a 15 or 20-year 
life and a 150 percent declining balance method. A computer 
used to run a highly sophisticated nuclear power plant cannot 
be expected to be less susceptible to obsolescence than one 
used in a cigarette factory, for example, which currently is 
recovered within 7 years. The economic life of a process 
control computer is not closely related to economic life of the 
manufacturing equipment it operates. It belies common sense to 
treat a process control computer any differently than a 
computer used to administer normal business transactions, yet 
these computers perform much more sophisticated ``high 
technology'' processes than normal business computer 
applications.
    Mr. Chairman, to more fully explain the inequities inherent 
in current depreciation rates and methods, we have attached a 
copy of a letter we submitted to Treasury last November that we 
hope can be incorporated into this Subcommittee's formal 
record.

                    CONCLUSIONS AND RECOMMENDATIONS

    We applaud this Subcommittee's efforts to take a long 
overdue look at the current Federal income taxation system with 
respect to capital recovery periods. We agree with the 
conclusions of a recent Treasury report and urge you to act on 
its findings. The Treasury Report (Report to the Congress on 
Depreciation Recovery Periods and Methods) states:
    ``Electric, gas, water, and telephone utilities were all 
generally regulated at the time the current class lives were 
established. Under rate of return regulation, utilities were 
not theoretically concerned with depreciation and tax expense, 
because rate structures were based on cost-plus pricing. A 
utility's rate of return on equity was largely independent of 
its tax or depreciation expenses. Consequently, for public 
utilities, it is unclear that existing class lives truly 
represent the actual useful lives of the property involved.
    Class lives may be expected to be different in the current 
more competitive environment. Producers must maintain state-of-
the-art equipment, which might mean shorter lives and more 
rapid depreciation. For example, new generations of combined 
cycle gas turbine generators are more efficient today than 
previously, leading to a more rapid retirement of such 
equipment than would have occurred under regulation.'' [At page 
97].
    Congressional action is needed to cure the power supply 
emergency facing our country. We encourage you to modernize the 
tax treatment of new electric generating capacity to reflect 
the technical, environmental and economic realities of the 
current structure of the electric industry. Doing so would 
greatly advance the public interest by insuring against the 
dire economic consequences that necessarily accompany 
electricity shortfalls. Failing to do so would benefit no one.
    In recognition of the need to modernize the capital cost 
recovery system for electric generation assets, we wish to 
commend Ways and Means Committee members Thomas, Jefferson and 
English for their leadership in introducing H.R. 4959 to modify 
the depreciation of property used in the generation of 
electricity. We believe this is a significant first step in 
helping our nation avoid an electric supply crisis which would 
harm all segments of our economy.
    We would be pleased to provide this Committee with more 
information about our industry's views on depreciation rates 
and methods for facilities used in the generation, transmission 
and distribution of electricity, and how the current system 
discourages investment in badly needed new generation capacity 
that is necessary to fuel economic growth in this country. We 
thank you for the opportunity to participate in this process.

                                  Business Operations Group
                                                   November 1, 1999
Department of the Treasury
Office of Tax Analysis
Room 4217, Main Treasury Building
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Re: Notice 99-34; 1999-35 IRB 1; Depreciation Study

    Dear Sir or Madam:

    The Edison Electric Institute (``EEI'') is pleased to offer the 
following comments in response to Notice 99-34; 1999-35 IRB 1 which 
requested public comment and recommendations for possible improvements 
to the current depreciation system under section 168.
    EEI is the association of U.S. investor-owned electric utilities, 
their affiliates and associated members worldwide. EEI is serving 
approximately 75 percent of the nation's electric customers and 
generate approximately three-quarters of all the electricity generated 
by all electric utilities in the country.
    EEI is concerned that the recovery periods permitted under section 
168 for assets used to produce and distribute electricity are much 
longer than the recovery periods allowed to other capital intensive 
industries. Indeed, this disparity has been present in nearly every 
depreciation or cost recovery regime since the 1970's. While there may 
have been a justification for this difference a number of years ago, 
today we believe that the industry has much more in common with other 
capital intensive industries. In the last five years, the electric 
industry has begun a transformation from a regional, vertically 
integrated, rate regulated business to a national (or international), 
industry consisting of three components: generation, transmission and 
distribution. Most generation plant investments will be non-regulated. 
As in every other instance of a heavily regulated industry undergoing 
deregulation, new technology is being developed and deployed at a much 
more rapid pace that competes with and makes obsolete many prior 
investments in property, plant and equipment. With most of our 
industry's assets placed in the 15-year and 20-year recovery period, 
the present cost recovery system unjustly penalizes our investors and 
makes capital formation much more difficult.

MACRS Cost Recovery Periods

    Under section 168, the cost recovery period of assets is generally 
determined by reference to the midpoint class life for the asset 
guideline class in which such property is classified under Rev. Proc. 
83-35, 1983-1 C.B. 745. Section 168 (e)(1) specifies (in relevant part) 
that property shall be treated as
    10-year property if such property has a class life of 16 through 19 
years,
    15-year property if such property has a class life of 20 through 24 
years, and
    20-year property if such property has a class life of 25 or more 
years.
    Section 168 (b)(1) sets the applicable depreciation method as the 
200 percent declining balance method except that section 168 (b)(2) 
allows only the 150 percent declining balance method for any 15-year or 
20-year property. The application of these rules results in the 
following depreciable lives for assets used in the electric industry as 
published in Rev. Proc. 87-56:
    Hydraulic Production Plants, Steam Production Plants, and 
Transmission and Distribution Plant (asset classes 49.11, 49.13, and 
49.14 respectively) have 20-year lives,
    Nuclear Production Plants and Combustion Turbine Production Plants 
(asset classes 49.12 and 49.15) have 15-year lives,
    Nuclear Fuel Assemblies (asset class 49.121) have 5-year lives.
    Thus, the lion's share of the investment in the electric industry 
must be depreciated over 20 years using the 150 percent declining 
balance method.
    One can scan Rev. Proc. 87-56 and note that very few asset classes 
have a 20 year life; aside from electric industry assets there are only 
twelve.\1\ Indeed, out of 133 asset classes identified in the Revenue 
Procedure only fifteen have even a 15-year life. The only manufacturing 
assets included among the fifteen are assets used to manufacture 
cement. As a matter of fact, most manufacturing assets have a 7-year 
depreciable life and are permitted use of the 200 percent declining 
balance method. For example, the following manufacturing categories 
have assigned lives that are less than half as long as most electric 
industry assets:
---------------------------------------------------------------------------
    \9\ They are:
    class 01.3 Farm Buildings,
    class 40.2 Railroad Structures classified as Public Improvements 
Construction,
    classes 40.51, 40.53, and 40.54 Railroad Electric Generation 
Equipment,
    class 48.11 Telephone Central Office Buildings,
    class 48.33 TOCSC-Cable and Long-line Systems,
    classes 49.21 and 49.221 Gas Utility Distribution and Manufactured 
Gas Production Facilities,
    class 49.3 Water Utilities,
    class 49.4 Central Steam Utility Production and Distribution, and
    class 51 Municipal Sewers.

---------------------------------------------------------------------------
7-year cost recovery

    Pulp and paper mills, Steel mills, Manufacture of locomotives and 
railcars, Lumber mills
    Foundries, Auto plants, Ship building

5-year cost recovery

    Chemical plants, Manufacture of electronic components and 
semiconductors
    The disparity between electric industry recovery periods and the 
recovery periods of other industries is highlighted upon review of 
asset class 00.4 Industrial Steam and Electric Generation and/or 
Distribution Systems. This asset class includes equipment identical to 
that used by the electric industry except that the energy generated is 
used in an industrial manufacturing process instead of being sold to 
others. This asset class is given a 15-year life. The same assets in 
the hands of an electric company would have a 20-year life.
    Another area of concern for our industry are the restrictions 
contained in the description of class life 00.12 Information Systems 
that further compounds the disadvantage suffered by our investors. The 
description excludes computers that are an integral part of other 
capital equipment, thus, giving computers used in a power plant control 
room a 15 or 20-year life and a 150 percent declining balance method. A 
computer used to operate a highly sophisticated nuclear plant cannot be 
expected to be less susceptible to obsolescence than one used in a 
cigarette factory or a textile mill which currently is recovered within 
7 years. The economic life of a process control computer is not closely 
related to economic life of the manufacturing equipment it operates. It 
belies common sense to treat a process control computer any differently 
than a computer used to administer normal business transactions, yet 
these computers perform much more sophisticated ``high technology'' 
processes than normal business computer applications.
    The power plants that manufacture electricity have lives that are 
similar to the production equipment listed above that have recovery 
periods in the 7 year range. The advantageous recovery periods allowed 
by Congress were given to encourage modernization of the nation's 
industrial base and to improve productivity. As discussed below, the 
electric industry is entering a period of great change. It is now 
appropriate to reexamine the traditional electric utility recovery 
periods and bring them in line with other industries.

The Present and Future State of the Electric Industry

    Until the 1990's the investor-owned electric industry was composed 
entirely of single State or regional companies that were closely 
regulated by the various State public utility commissions. Companies 
were vertically integrated in that they generated power, transmitted 
the power across their region and then distributed the power to each 
customer. The companies operated as monopolies and had an obligation to 
serve all customers.
    In this sort of market utilities may have had a greater expectation 
of recovery of their investment than in a more competitive marketplace. 
Furthermore, a regulated company had little incentive to retire its 
assets before the end of their technological life in order to deploy 
new technology. To have done so might have resulted in increased costs 
to customers that would have been unpalatable to State commissions. 
This monopoly status may explain why electric assets have historically 
had such long recovery periods. Such is not the state of the industry 
today.
    One by one States are unbundling the electric industry and 
introducing competition. Generally, three distinct businesses are 
formed: generation, transmission, and distribution. In order to keep 
incumbent utilities from enjoying an early market advantage, States are 
often structuring market rules such that the incumbent utilities sell 
off large numbers of their generation plants. For example, California 
utilities sold off half of their fossil fuel plants as part of that 
State's restructuring plan. With the proceeds of these sales, many 
utilities (or former utilities) are investing in non-regulated 
generation plants in other regions of the country. This newly 
competitive marketplace is encouraging the introduction of newer 
technology. Cleaner burning natural gas plants are being built to 
compete with coal fired plants. As many nuclear plants are shut down, 
replacement energy is being generated by new, non-regulated plants. In 
this marketplace, investors in electric generation have no guarantee of 
recovery. As in any other business they will have no control over 
other, cheaper sources of supply that will attract away their 
customers.
    An example of the effect of technological innovation is the rapidly 
increasing deployment of combined cycle gas turbine generators. 
Combined cycle generators increase efficiency by producing electricity 
from otherwise lost waste heat. Today's state-of-the-art combined cycle 
generators operate at energy conversion efficiency levels of 70 percent 
compared to 40 percent to 50 percent a decade ago. Competitive pressure 
is forcing owners of units less than a decade old to make costly 
improvements to increase operating efficiency.
    In addition to the competitive threats facing the generation 
segment of the electric industry, transmission and distribution are 
facing competitive threats from gas pipelines and the location of 
generation along gas pipelines. Not only is gas a competitive energy 
source, but gas pipelines with capacity to serve generating plants can 
substitute for portions of transmission lines. Locating new generation 
along gas pipelines is, in effect, a mechanism for transporting 
electrons by moving gas. Longer term, numerous threats are emerging to 
place transmission owner revenues at risk. These include the location 
of generation nearer to loads, changes in electricity consumption 
patterns, and new technology.
    In fact, one rapidly emerging new technology is Distributed 
Generation. Distributed Generation refers to electric power produced 
using fuel cell technology or on-site small scale generating equipment 
that can displace power generated by a central station generating unit. 
Because they can be sited on a customer's premise, their widespread use 
would effect the economic life of transmission and distribution assets 
as well as generating plants.
    In EEI's view, the fundamental changes taking place in the electric 
industry must be acknowledged and taken into account in the current 
cost recovery system. We note that recently many industry groups have 
publicly expressed a need for shorter recovery periods. In every case, 
these industries already have recovery periods of 5-years, 7-years or 
10-years. Although we don't seek to diminish the arguments put forward 
by other industries, we do believe that our industry is bearing the 
biggest penalty under the present system. The disparity is so great 
that we believe that shortening electric industry lives must be acted 
upon before adjusting any other industry's lives. We believe the 
current system provides incentives that direct capital formation away 
from our industry. As a matter of fundamental fairness, the cost 
recovery system must take into account marketplace changes that 
radically effect the economic useful lives of assets.
    We would be pleased to provide you with any other information that 
you might find helpful. Please feel free to contact Mr. Cary Flynn of 
Duke Energy at 704/382-5918. We would also welcome the opportunity to 
meet with you personally to further discuss our views.
            Sincerely,
                                             David K. Owens
                                           Executive Vice President
      

                                


    Chairman Houghton. Okay; thanks very much, Mr. Vogel.
    Mr. von Unwerth?

    STATEMENT OF FREDERICK H. VON UNWERTH, GENERAL COUNSEL, 
           INTERNATIONAL FURNITURE RENTAL ASSOCIATION

    Mr. Von Unwerth. Mr. Chairman, members of the Subcommittee, 
I appear here today on behalf of the International Furniture 
Rental Association. I am the association's general counsel. I 
thank you for this opportunity to say a few words about a 
problem for the furniture rental industry that has surfaced 
recently with the Internal Revenue Service.
    We are a small industry, and I believe the problem is 
straightforward, so I won't take much of your time. The 
industry I represent is the traditional furniture rental 
industry, not to be confused with the rent-to-own industry. The 
Congress specifically addressed the depreciation recovery 
period for rent-to-own property in the Taxpayer Relief Act of 
1997, declaring it 3-year property through an amendment to 
Section 168(e) and 168(i).
    The members of our industry are in the ``rent-to-rent'' 
business. It's a service business. We provide short-term 
furniture rentals for the convenience of customers temporarily 
in need of furniture. All of our members rent furniture for 
residential use to both consumers and businesses. Many of them 
also rent furniture for office use to individuals and 
businesses. Sometimes, it's the same furniture.
    It is the rental of furniture for office use that brings us 
here today. Now, there has never been any question that the 
traditional business of renting furniture falls within Class 
57, distributive trades and services, under the MACRS system. 
This classification qualifies the furniture held by the rental 
company taxpayer as 5-year property under MACRS. Until 
recently, there also has been no question that the taxpayer's 
rental of furniture to a customer for office use should be no 
different for depreciation purposes than his rental of 
furniture to a customer for residential use.
    In fact, a general information letter from the Service 
confirmed that the rental business itself, as a distributive 
trade and service business, qualified all the rental inventory 
as 5-year property. Both logic and fairness dictate the same 
depreciation schedule for the rental company taxpayer whether 
the desk, chairs, sofa and end table are rented to the customer 
for home use or office use. Of course, there's also the 
possibility of a residential customer's rental of furniture for 
home office use, of which the rental company may not even be 
aware.
    To treat these uses differently for depreciation of the 
furniture by the rental company would enormously and unfairly 
complicate the business of renting furniture. The problem 
furniture rental companies now face arises from an IRS 
interpretation of a Tax Court opinion in litigation involving 
the Norwest banking organization. The Cincinnati office and the 
Ohio Appeals Office have interpreted the Norwest opinion to 
mean that any general use asset category, such as office 
furniture, fixtures and equipment--that's class 00.11--always, 
regardless of the circumstances, takes precedence over any 
activity category, such as class 57, distributive trades and 
services.
    The Norwest case had absolutely nothing to do with rental 
furniture. It involved a claim by a bank that certain 
furnishings were being used in the distributive trade of retail 
banking, even though the bank's use of the furnishings was 
typical administrative office use. This specious claim was 
given short shrift by the Tax Court. The court specifically 
noted that there was nothing unique about the bank's use of the 
furniture.
    The court also made some observations about a revenue 
procedure dealing with priorities between asset categories and 
activity categories in general. It did not mention the specific 
use of office furniture by a furniture rental company as rental 
inventory.
    Nevertheless, based on the court's general observations in 
Norwest, the IRS in Cincinnati has demanded a change in 
accounting method by a Cincinnati-based furniture rental 
company for the depreciation of its rental office furniture 
inventory. The Service is insisting on a 7-year recovery period 
based on an asset classification as Office Furniture, Fixtures 
and Equipment under Class 00.11.
    The Cincinnati IRS position completely ignores the unique 
use of office furniture by the taxpayer as rental inventory, in 
which it is repeatedly moved in and out of warehouses, trucks, 
and customer premises between rentals. Because of the beating 
it takes in this unique use, rental office furniture generally 
has a rentable life of 3 to 4 years, even though the same 
furniture purchased or leased for long-term use by an ordinary 
business could last much longer. Thus, a 7-year recovery period 
for rental office furniture makes no sense. It is completely at 
odds with the goals of Code Section 167(a), which is to provide 
a ``reasonable allowance for the exhaustion, wear and tear...of 
property used in the [taxpayer's] trade or business.''
    To lay to rest this troubling interpretation that now hangs 
over the office furniture rental industry, we ask the committee 
to clarify the appropriate recovery period through an amendment 
to Section 168(e)(3)(A) and 168(i), specifically defining as 5-
year property all office furniture held by a furniture rental 
dealer for rental to businesses and individuals under short-
term leases.
    Thank you for your time and your consideration. If there 
are questions, I will be happy to try and answer them.
    [The prepared statement follows:]

Statement of Frederick H. Von Unwerth, General Counsel, International 
Furniture Rental Association

    Mr. Chairman and Members of the Subcommittee, I appear 
today on behalf of the International Furniture Rental 
Association. I am the Association's general counsel. I thank 
you for the opportunity to say a few words about a problem for 
the furniture rental industry that has surfaced recently with 
the Internal Revenue Service. We are a small industry, and I 
believe the problem is straightforward. So I won't take much of 
your time.
    The industry I represent is the traditional furniture 
rental industry, not to be confused with the rent-to-own 
industry. The Congress addressed the depreciation recovery 
period for rent-to-own property in the Taxpayer Relief Act of 
1997, declaring it 3-year property through an amendment to Code 
section 168(e)(3)(A) and 168(i).
    The members of our industry are in the ``rent to rent'' 
business. It is a service business. We provide short term 
furniture rentals for the convenience of customers temporarily 
in need of furniture.
    All of our members rent furniture for residential use to 
both consumers and businesses. Many of them also rent furniture 
for office use to individuals and businesses. Sometimes, it's 
the same furniture. It is the rental of office furniture that 
brings us here today.
    There has never been any question that the traditional 
business of renting furniture falls within Class 57.00, 
Distributive Trades and Services, under the MACRS system. This 
classification qualifies the furniture held by the rental 
company taxpayer as 5-year property under MACRS.
    Until recently, there also has been no question that the 
taxpayer's rental of furniture to a customer for office use 
should be the same for depreciation purposes as its rental of 
furniture to a customer for residential use. In fact, a general 
information letter from the Service confirmed that the rental 
business itself, as a distributive trade and service business, 
qualified all the rental inventory as 5-year property.
    Both logic and fairness dictate the same depreciation 
schedule for the rental company taxpayer whether the desk, 
chairs, sofa and end table are rented to the customer for home 
use or for office use. Of course, there is also the possibility 
of a residential customer's rental of some furniture for home 
office use, which may be unknown to the rental company. To 
treat these uses differently for depreciation of the furniture 
by the rental company would enormously and unfairly complicate 
the business of renting furniture.
    The problem furniture rental companies now face arises from 
an IRS interpretation of a Tax Court opinion in litigation 
involving the Norwest banking organization. The Cincinnati 
office and the Ohio Appeals Office have interpreted the Norwest 
opinion to mean that any ``general use'' asset category, such 
as Office Furniture Fixtures and Equipment (Class 00.11), 
always, regardless of the circumstances, takes priority over 
any ``activity'' category, such as Class 57, Distributive 
Trades and Services.
    The Norwest case had absolutely nothing to do with rental 
furniture. It involved a claim by the bank that certain 
furnishings were being used in the distributive trade of retail 
banking, even though the bank's use of the furnishings was 
typical office use. This specious claim was given short shrift 
by the Tax Court. The Court specifically noted that there was 
nothing ``unique'' about the bank's use of the furniture. The 
Court also made some observations about a Revenue Procedure 
dealing with priorities between ``asset'' categories and 
``activity'' categories in general. It did not mention the 
specific use of office furniture by a furniture rental company 
as rental inventory.
    Based on the Court's general observations in Norwest, the 
IRS in Cincinnati has demanded a change in accounting method by 
a Cincinnati-based furniture rental company for the 
depreciation of its rental office furniture inventory. The 
Service is insisting on a 7-year recovery period based on an 
asset classification as Office Furniture, Fixtures and 
Equipment under Class 00.11.
    The Cincinnati IRS position completely ignores the unique 
use of office furniture by the taxpayer as rental inventory, in 
which it is repeatedly moved in and out of warehouses, trucks, 
and customer premises between rentals. Because of the beating 
it takes in this unique use, rental office furniture generally 
has a rentable life of 3 to 4 years, even though the same 
furniture purchased or leased for long term use by an ordinary 
business could last much longer. Thus, a 7-year recovery period 
for rental office furniture makes no sense. It is completely at 
odds with the goal of Code Section 167(a), which is to provide 
a ``reasonable allowance for the exhaustion, wear and tear. . 
.of property used in the [taxpayer's] trade or business.''
    To lay to rest this troubling interpretation that now hangs 
over the office furniture rental industry, we ask the Committee 
to clarify the appropriate recovery period through an amendment 
to section 168(e)(3)(A) and 168(i), specifically defining as 5-
year property all office furniture held by a furniture rental 
dealer for rental to businesses and individuals under short 
term leases.
    Thank you for your time, and your consideration. If there 
are questions, I will be happy to try to answer them.
      

                                


    Chairman Houghton. Thank you very much, Mr. von Unwerth.
    Now we will go to questions of the panel. Mr. Coyne?
    Mr. Coyne. Thank you, Mr. Chairman.
    My question is to Mr. Jernigan. You indicated that over the 
last several years your company has been forced to move much of 
your operation overseas. What is it either in the tax code or 
other regulations that we have here in the country that--why is 
it that you find it necessary to do so much business overseas 
instead of here in the United States?
    Mr. Jernigan. Let me first say that we are still building 
in the United States, but we recently completed about a $2 
billion facility in Dresden, Germany. Capital recovery is a 
major aspect of why we chose to go overseas. The United States 
is just not a very good place to invest today.
    And, secondly, we couldn't find employees. You are aware of 
the H-1B issue. Germany had an abundance of engineers. We have 
a very difficult time finding engineers in this country.
    Mr. Coyne. Well, relative to the H-1B situation, has your 
company or your associations been involved in any attempt to do 
more training of U.S. prospective employees for the industry?
    Mr. Jernigan. Absolutely. We have training programs, 
vocational training programs in our company. We support the 
Semiconductor Research Corporation, which puts money into 
universities to help train individuals. We spend millions as a 
company and an industry to try to train people.
    Mr. Coyne. Have you had much success in those efforts?
    Mr. Jernigan. Yes.
    Mr. Coyne. Or is still one of the driving forces to push 
you overseas?
    Mr. Jernigan. It is still a prime consideration as to why 
we went overseas the last time around.
    Mr. Coyne. Even though you have had some success in these 
training efforts?
    Mr. Jernigan. Yes.
    Mr. Coyne. They are just not enough.
    Mr. Jernigan. Not enough.
    Mr. Coyne. Thank you.
    Chairman Houghton. Mr. Weller?
    Mr. Weller. Thank you, Mr. Chairman. I think one clear 
message I have gotten from this panel is that, of course, our 
current tax code is stymieing innovation and advancement of 
technology and is actually depressing the opportunity for 
higher wages for workers in this country. And that is why I 
think your hearings are so very, very important.
    I recognize we have got a number of people on the panel 
and, of course, a limited amount of time. I just want to direct 
my first question, I think, to Ms. Coleman. As you know, of 
course, we have worked with your organization on the issue of 
depreciation treatment of office computers, as we have with 
others that are on this panel. Currently, the office computer, 
you carry it on the books for 5 years. Do you feel that that is 
an accurate reflection of the life of those office computers?
    Ms. Coleman.I certainly think that your legislation to 
expense office computers is an excellent first step, and I 
think the NAM believes that all business equipment should be 
expensed.
    Mr. Weller. You indicated you support expensing. You know, 
one of the questions I am often asked--and I have been given 
the figure of 12 to 14 months is apparently how often that many 
businesses replace that computer, the PC that sits on the desk. 
Is that an accurate figure?
    Ms. Coleman.I am not really in a position to comment on 
that right now, but I would be happy to get back to you.
    Mr. Weller. Okay. Are there any others on the panel that 
can share with us just from their possible, Mr. Jernigan, 
maybe? You are in the business.
    Mr. Jernigan. I think we are replacing computers in our 
company about 2 to 2 and a half years.
    Mr. Weller. So that 12 to 14 months may be a little too--
    Mr. Jernigan. I don't know the answer.
    Mr. Weller. Okay. Anyone else on the panel on that 
turnover, on 12 to 14 months?
    [No response.]
    Mr. Weller. One of the questions that clearly was raised 
when Treasury was before us was--you know, they took 2 years to 
do their study, which is a long period of time. It is a 
lifetime in the time of Congress let alone in the business of 
technology where we have seen such rapid changes in the last 2 
years, let alone the last 5 or 10. And they indicated that they 
had failed to collect any empirical data regarding to when it 
comes depreciation treatment of technology.
    I was wondering, Do your organizations, have any of you 
collected any empirical data that might help us better 
understand and better prepare as we work towards depreciation 
reform? Any organizations? Mr. Jernigan?
    Mr. Jernigan. Yes. The semiconductor industry has done 
three studies over the last 15 years in conjunction with people 
in the Treasury Department, working with them on the 
methodology, et cetera. They are reluctant to still endorse the 
studies, but they actually helped to participate in the studies 
with the outside consulting firms we used.
    The last study we did showed that semiconductor 
manufacturing equipment has an economic life of just about 3 
years, and that study was done 5 years ago, and I am sure the 
life of our equipment is less today.
    Mr. Weller. Okay. Tying in with that, Mr. Jernigan--and I 
would very much like to see your material as we work on the 
depreciation reform.
    Mr. Jernigan. We will provide it to you.
    Mr. Weller. This is my last question I just want to direct 
to you. You mention in your testimony how other countries 
provide for depreciation treatment of technology, and, of 
course, our chief competitors are in Europe and Japan. Can you 
share with us what their depreciation schedules on PCs, for 
example?
    Mr. Jernigan. In the depreciation area, their lives are 
generally equal to better than ours. But then it is in the fine 
print that they give you the better incentives. Japan has a 5-
year life, but they give you extra depreciation if you are 
located in special zones or if you use the equipment over 24 
hours a day. So, in looking at Japan, we have noted that they 
offer an 88 percent write-off in the first year and up to 113 
percent write-off after 3 years.
    Other countries, and our experiences with Germany, will 
essentially pay for half the plant. And we know some companies 
in our industry where the plant was almost totally paid for, 
and that has been the case in Italy. We know that Taiwan is a 
major country today. In fact, the Government of Taiwan is 
thinking that their plants now will buy more semiconductor 
equipment in 2 years' time than in the U.S. In other words, 
everyone is going to Taiwan because of all the additional 
incentives: short depreciation, cash grants, low interest rate 
loans, on and on and on.
    I think our Treasury Department was talking about, well, it 
looks like there isn't much difference between our country and 
other countries. If you look at just the plain depreciation 
rules, probably the differences aren't that great. It is in the 
other incentives that they offer, which are cash recovery 
incentives that oftentimes equate to expensing and sometimes 
even expensing plus incentives.
    Mr. Weller. That is very helpful. Thank you.
    Thank you, Mr. Chairman, for the opportunity to ask 
questions.
    Chairman Houghton. Thank you.
    Mr. Watkins?
    Mr. Watkins. Thank you, Mr. Chairman. I, too, would like to 
thank you for having these hearings and having this, I think, 
very appropriate time to discuss this. The high-tech industry, 
we do have a tremendous crisis ahead of us, I think.
    Mr. Jernigan, have you looked at Native Americans? We do 
have tax incentives, but many companies will not look at Native 
Americans, and we do have accelerated depreciation. We have got 
some nice tax credits. For instance, in my district I have 
surveyed them. I am going through career tech, low-tech stuff, 
and there are 8,000 people or more that right now have had some 
high-tech. But many industries have not looked at going into 
small- town rural America, and I would like to encourage you 
not to overlook that, especially with the Native Americans. 
Many of them are really highly, well qualified and can do a 
great job, but sometimes we are always left out. As I said last 
time, don't overlook--do go over rural America going somewhere 
else when we do have that need.
    I am back here because of that reason. I was a businessman 
in small- town rural America and trying to make things work, 
and out-migration, the lower unemployment, we have people who 
live out there, and one of the biggest problems in high-tech is 
needing a stabilized workforce. We have that in rural America. 
That is why they are living out in the small- town rural 
America because they want to stay there and live there and work 
there and raise a family there. All we want to do is have the 
opportunity there. And I have been working some pilot areas to 
try to get there.
    We do have tax incentives there to be able to help us do 
some of the things, so I want to encourage you, and I would 
welcome any of you to let me visit with you in my office or 
your office about that. I am here in this Congress trying to 
rebuild the economic livelihood of people who have been left 
behind since the Great Depression, let alone just in this time.
    You know, history books, we can look back at history books, 
and we know the Industrial Revolution was one of the major 
launching pads of this great country. But we are living through 
two revolutions now, yes, the information technology 
revolution, but also globalization. Both those are revolutions 
taking place right now in our lifetime, and I would like to 
just leave you with the fact that we need to try to make sure 
all of America happens to be worthy of these incentives.
    I came back also because I wanted to try to help shape a 
global competitive economy for the United States. We balanced 
the budget, which I think is really important, but a global 
competitive economy is one that has got less taxation. We have 
got to have less taxation, Mr. Chairman. We have got to be lean 
and mean on taxation if we are going to compete in a global 
economy. The same way with less regulation--
    Chairman Houghton. You can be leaner and I will be meaner.
    Mr. Watkins. You will be meaner, yes, sir, Mr. Chairman. 
But less regulation and less litigation. In fact, if you look 
at it, industry trying to compete around the world today, they 
got a 15 percent overburden when you look at the tax, over 15 
percent overburden when you look at taxation and the regulation 
and the litigation when we start trying to compete with the 
world. And I want to try to give you some relief in a lot of 
those areas. That is why I am working with my friend Jerry 
Weller here on his depreciation bill that we have got to have 
to help with the new economy. And I just want to--I guess maybe 
I am making more comments than I am asking any questions, but I 
am pleading with you not to overlook rural America out in those 
areas. I have got 21 counties in Oklahoma, and like I say, none 
of them on their own probably can support a major industry, but 
when we pull them together in the aggregate, we can provide 
tremendous opportunities. And they can do that in Illinois, 
they can do that in a lot of other areas around the country.
    Have you any industry working with the Native Americans?
    Mr. Jernigan. Mr. Watkins, we will invest in any area--it 
could be Native Americans or a black community or Asian. That 
is not important to our industry. We will go where the jobs are 
and where the people are well trained. And I would be very 
happy to sit down with you and give you my perspectives of what 
Oklahoma will need to do to attract semiconductor jobs.
    I know that Oklahoma will attract some major semiconductor 
plants. You have a very aggressive economic development 
program. You have come very close to attracting some major 
plants already, and I would, as I say, be very happy to sit 
down and give you my perspective on that. I could be available 
this afternoon or--
    Mr. Watkins. I will be available right after you get up 
from that table.
    Mr. Jernigan. Okay, you are on. You have got a date.
    Mr. Watkins. Anybody else available?
    [Laughter.]
    Mr. Watkins. Thank you, Mr. Chairman, very, very much.
    Chairman Houghton. Thanks very much, Mr. Watkins.
    Mr. Portman?
    Mr. PORTMAN. Thank you, Mr. Chairman, and I really 
appreciate all the input we are getting from this panel and the 
previous panel, and I commend the chairman for holding this 
hearing. We probably don't have time this year to legislate in 
this area, but now that we do finally have the Treasury report 
in hand, we do have some data with which to work. There are no 
legislative recommendations, as you know, in the Treasury 
report, nor apparently in the earlier testimony from Treasury 
did we hear any specific recommendations. So it kind of falls 
back on this panel and others in Congress to figure out what 
might be the best course to take.
    I have heard today a lot of specific concerns, and it seems 
to me that to address one area or another might not be the 
wisest approach, although there certainly are some areas that 
need immediate relief in the high-tech area. But it seems to me 
we do need to have a revamping, and it seems to me that it 
ought to be something that this committee works on immediately 
in the new year.
    I have a couple questions for the panel, if I might, and a 
couple of specific questions, if I could, Mr. Chairman, for von 
Unwerth.
    A general question. Should we give Treasury more 
discretion--I mean, again, I hear from low-tech to high-tech 
companies that the class life or category is inaccurate for 
this product or that, that the cost recovery is not appropriate 
because of changing conditions, you know, new technologies 
among other things, that it is just impossible, frankly, for 
Congress to legislate in this area and keep up with it.
    The 1986 act gave the Treasury Department more discretion, 
as you know, to determine what the appropriate class life was. 
In essence, we gave them discretion to, therefore, change what 
some cost recoveries were and change the taxes that you pay.
    We kind of pulled that authority back to Congress, partly 
in response, I understand, to constituent concerns. I wasn't 
here then. It was slightly before my time. But I wonder if I 
could get the panelists who were in the business at that time 
and dealing with Treasury or those who have looked back on that 
period to give us some input as to whether we should give 
Treasury more discretion in that area. Does that make sense? 
Ms. Coleman, do you have a thought on that?
    Ms. Coleman.Well, I have to admit, I wasn't involved in the 
issue at that time. Certainly, I think--
    Mr. Portman. You and I were both in high school at the 
time.
    Ms. Coleman.I wish.
    I think the time that it took to do just this study that 
they released in July, points to how time-consuming it would be 
to update the current system.
    Mr. Portman. It took 2 years, and there are no 
recommendations.
    Ms. Coleman.Pardon me?
    Mr. Portman. I am just agreeing with you.
    Ms. Coleman.We support moving to an expensing system, which 
would be a lot more straightforward and certainly easier to 
administer and develop.
    Mr. Portman. And with an expensing system, you wouldn't 
have to worry about making some of these decisions, changing 
classifications. You would have immediate expensing. And you 
talked about a transition to that. How about, though, others of 
you who, if we were to stay with a depreciation system, would 
it make sense to give Treasury more discretion? Mr. Jernigan?
    Mr. Jernigan. I think it definitely would. I think you need 
to give Treasury broad guidelines that are intuitively correct. 
As Congressman Weller said, he can't believe that a computer 
has a 5-year class life, and we all know that maybe it should 
be 2 years or 1 and a half years. So I think you need to give 
Treasury a mandate and strong guidance that you have got to be 
realistic, also.
    We don't always have that data out there, or it is very 
expensive to collect that data. In our industry, the 
semiconductor industry, we have done three studies, and the 
studies are very time-consuming, they are very expensive. You 
have to hire outside people. And then when you turn over the 
study to the Treasury, it just gets lost. And industries don't 
have the manpower and the time and the money to do all these 
studies.
    So broad guidelines to Treasury encouraging them to be more 
realistic and intuitive in what they are doing I think would be 
very useful.
    Mr. Portman. Including maybe mandated reviews or sunsetting 
or different classifications or class lives to force them to 
take a look at the reports or the data that you would submit. 
How about any other comments on that, is anybody fearful of 
giving Treasury that kind of discretion? Mr. Vogel?
    Mr. Vogel. Well, as I think you are aware, Treasury has had 
a lot of authority over the years, and that is where the 
guidelines that we currently live with today came out of in the 
early 1960s. And what I think we see is that it is a slow, 
ponderous process. It is heavily fact-driven. The Treasury 
report itself that recently came out, really weighed lots of 
different directions that they could go in terms of deciding 
how should the assets be depreciated, over what life, and what 
kind of results are we trying to achieve.
    To some extent, what happened in 1981 was a superb 
development in that what happened was we set aside the notion 
of sort of trying to carefully tweak the depreciation to match 
what lives are being experienced and called it something 
different, called it ``accelerated capital cost recovery.'' And 
the concept was that we are getting away from this traditional 
notion of how long these assets live and recognizing that what 
we have got really going on is the need to recovery your 
capital and recover it in a timely manner and recover it on a 
real dollar value basis so that the effects of inflation do not 
destroy the capital base of the country.
    And that is the system we are on today, and I think 
Congress took the lead in enacting that kind of system. So I 
think it would be risking longer periods of stagnation if it 
were put back into a merely administrative process. I think 
that is why we have suggested that, you know, the only way to 
timely address the changing nature of our industry is for 
Congress to act.
    Mr. Portman. You mentioned inflation. Another idea going 
beyond cost recovery is to actually index depreciation 
schedules to inflation. With low inflation, I assume your cost 
recovery has been relatively good, although relative to other 
countries, Mr. Jernigan, it doesn't make any difference because 
I don't think any other of our major competitors handle 
inflation any differently than we do. Although with low 
inflation, maybe that is not as big a concern today with you. 
One idea would be that Congress could mandate that at a 
minimum. There is an expense to that, of course.
    Mr. Vogel. I think Treasury's report discussed some of the 
problems of identifying one area for inflation adjustment.
    Mr. Portman. Well, I appreciate again the input, and I 
thank the chairman for taking on this issue. He is a brave 
soul, mean, lean, and courageous.
    I have one other question, if I could, Mr. Chairman, with 
regard to the final testimony we heard today with regard to the 
rental furniture.
    You said in your comment, Mr. von Unwerth, that the 
rentable life of this equipment is 3 to 4 years, which is 
inconsistent, it seems to me, with what you are calling for, 
which is to simply go back to a clarification that the five-
year recovery period is proper. Why wouldn't you ask for three 
to four years rather than sticking with the five years or 
clarifying the five years?
    Mr. Von Unwerth. Well, you make a very good point. Thank 
you, Mr. Portman. We are sort of right on the cusp of a class 
life. We are about four years, three to four years, and the 
class life difference between three and five-year property is 
right at that. The breakpoint is between four and five -four 
years and under for three-year propoerty, five to nine years 
for five-year property. The next breakpoint, for seven-year 
property is 10 years and up. We know we shouldn't be there.
    Mr. Portman. Yes. And you have got an IRS ruling, you said, 
out of my hometown IRS office, Cincinnati, Ohio, for 7.
    Mr. Von Unwerth. They have insisted on a change of 
accounting method to go to 7 years for one of the national 
office furniture rental companies that is headquartered in 
Cincinnati. That makes no sense. Everybody else is doing 5 and 
always has. We do think there is a case to be made for 3, but 
we are not here asking for that. All we are seeking at this 
point is simply a clarification that 5 is the fair and proper 
interpretation.
    Mr. Portman. Three years is what the rent-to-own industry 
has now?
    Mr. Von Unwerth. That is what the rent-to-own industry has. 
Yes, that is correct.
    Mr. Portman. Okay. But you are just asking for a 
clarification that the 5-year recovery period is proper.
    Mr. Von Unwerth. That is correct.
    Mr. Portman. Under the current system. And when you say 
short-term leases, what are you talking about?
    Mr. Von Unwerth. One year or less. They are typically in 
the industry one year or less. The legislation we propose would 
define short -term as one year or less and would define a 
qualified dealer as one who leases primarily pursuant to short-
term leases. We are not talking about anything like a finance 
lease here. This is rental.
    Mr. Portman. And the revenue differential between 5 and 7 
years' recovery would be what for rental?
    Mr. Von Unwerth. About a million and a half a year, maybe 2 
million. That is based on an assumption of 75 to 100 million of 
property annually placed in service by the entire industry.
    Mr. Portman. That is all?
    Mr. Von Unwerth. As I said, this is a very small industry.
    Mr. Portman. Okay. Thank you very much. I appreciate your 
testimony, and I thank all of you for helping us out. Maybe we 
will see you again next year.
    Thank you, Mr. Chairman.
    Chairman Houghton. Thank you very much, Mr. Portman. I have 
just got a couple of questions to wind this thing up. First of 
all, Mr. Jernigan, you know, when Brazil or Japan or Germany 
are giving these terrific incentives, I don't think that really 
gets into depreciation. I mean, that is an outright incentive, 
and I don't think that this particular panel can handle this 
particular--that is another issue, important as it might be.
    Also, Mr. Jalbert, you talked about R&D tax credits. The 
same thing, I think it is very important, that we ought to do 
it, but I don't think we can handle that.
    I think the thing that I am interested in is almost a 
redefinition of Section 167. Rather than the wear and tear and 
the obsolescence, you have other factors you are talking about. 
In sort of simple language, it is a Moore's Law of every 
industry. And so the question is more than wear and tear, it is 
competition, it is rejuvenation, it is inflation.
    I could make a strong case, I think, for the iron and steel 
industry, that they should have the special accelerated 
depreciation because they are so much in the doldrums, as 
contrasted to the wireless industry, because you have been able 
to do particularly well.
    However, when you take a look at the pressure from abroad 
and the incentives which are given there on depreciation 
itself, it makes it very, very difficult.
    So I wonder how we sort this thing out and help the 
Treasury redefine that Section 167. Maybe you have some ideas.
    Mr. Jernigan. Do you want me to start?
    Chairman Houghton. Sure.
    Mr. Jernigan. Okay. Well, as I have said, the U.S. 
semiconductor industry has submitted three studies to Treasury 
which I think are quite compelling and were done under the 
auspices and guidance of Treasury. I think that would be a good 
starting place. The last study we showed was 3 years. I think 
Treasury ought to recommend to the Congress that we have a 3-
year life and Congress ought to act on it expeditiously as 
opposed to waiting for comprehensive reform, which may be two 
or three more generations of semiconductor plants.
    Chairman Houghton. Have you seen the report to Congress on 
depreciation recovery from the Treasury?
    Mr. Jernigan. I have only read it once through because it 
was about 130 pages, but I have seen it. The July study.
    Chairman Houghton. Yes.
    Mr. Jernigan. Yes. It doesn't address the issues very 
adequately for us. It is more of--
    Chairman Houghton. Well, look, this panel is trying to get 
at the issue. We are trying to find a resolution to this rather 
than just hearing things. And if you have some specific ideas 
which should be added to this, then we can pass it along or you 
can pass it along to Treasury, we would like to see them.
    Mr. Jernigan. We will do that, sir.
    Chairman Houghton. We would like to see something done. 
Okay. Now, Mr. Vogel or Ms. Feldman, any other suggestions we 
have here? Because we would like to move the ball forward here. 
Clearly, we are in an entirely different age now in terms of 
the depreciation schedules, and we would like to have some 
specific, very simple, one or two suggestions that the Treasury 
ought to use. But you have got to understand that there is a 
precedent to be set. When you do it for one industry, you have 
got to do it in some sense for another.
    Any other suggestions? How about you, Mr. Jalbert?
    Mr. Jalbert. I come here as a representative of the AEA, 
but I am also a businessman. And what I see is practicality, 
and I look at our book accounting versus our tax accounting, 
and I will take the example of the computer.
    We know our computers won't last more than 2, 2 and a half 
years, yet we depreciate them over 5. And that is just an 
example of how we are behind the times. And we have a company 
that has--we are in rural America. We are in Waseca, Minnesota, 
and in Lincoln, Nebraska. And when you think about that, we are 
a high-tech company and we have over 100 engineers. Yet we have 
openings for 20, and that is because of qualifications and that 
is because of training.
    So we have to do training in our own company. We are not a 
big company. We are between 55 and 60 million. But we spend 1 
percent of our revenue on training, and that is something that 
we would like to continue, especially for graduate work. So we 
look at graduate work and the tax incentives there. We look at 
depreciation and the opportunities there. And then finally, if 
you take a look at R&D credit, we are an industry that is 
driven by R&D. We are $55 to $60 million company, and we spend 
$6 to $7 million a year just on R&D. So the tax code has to be 
in tune with what is going on today.
    So the practicality for me as a businessman is we need to 
make some of these things permanent, we need to continue other 
things, and we need to re-examine how we do depreciation.
    Chairman Houghton. Any other comments, Ms. Coleman, Ms. 
Feldman?
    Ms. Feldman. Yes. With the rapid advances in technology, 
especially in the last 10 to 20 years, we would suggest instead 
of revamping everything we would suggest starting with some of 
the industries that have started up, like the wireless 
industry, in the more recent years that aren't specifically 
mentioned in the revenue procedure. It just raises questions by 
the IRS as to what our class lives are and what our recovery 
periods are. We think we know what they are, but it is a 
continuing audit issue amongst our companies that has not been 
resolved. To address industries such as ours that have the 
newer technologies might be a good starting point.
    Chairman Houghton. Ms. Coleman?
    Ms. Coleman.I think once again moving towards expensing 
would resolve a lot of these issues.
    Chairman Houghton. You would like to expense everything.
    Ms. Coleman.Pardon me?
    Chairman Houghton. You would like to expense everything.
    Ms. Coleman.Yes, I would. But being a broad-based trade 
group, I think one problem that we have is that some assets 
that have longer class lives are at a disadvantage vis-a-vis 
assets with a shorter asset life, which could distort 
investment decisions. And I think an expensing system would 
eliminate a lot of those problems.
    Chairman Houghton. All right. Fine. Anybody else, Mr. 
Vogel, Mr. von Unwerth? No comments? All right.
    Well, thanks very much. I certainly appreciate it. Any 
other suggestions you have for us to mull over, please send 
them in to us.
    The hearing is adjourned.
    [Whereupon, at 3:31 p.m., the hearing was adjourned, to 
reconvene at 11 a.m., Thursday, September 28, 2000.]


                    THE TAX CODE AND THE NEW ECONOMY

                              ----------                              


                      THURSDAY, SEPTEMBER 28, 2000

                  House of Representatives,
                       Committee on Ways and Means,
                                 Subcommittee on Oversight,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:00 a.m., in 
Room 1100 Longworth House Office Building, Hon. Amo Houghton 
(Chairman of the Subcommittee) presiding.
    Chairman Houghton. I don't mean to scare everybody, but I 
hope the meeting can come to order. We are appreciative of all 
of you being here, particularly our panel, and we are going to 
continue the hearing on the tax code and the new economy. As 
many of you know--I don't know whether you gentlemen were 
here--but our focus was on depreciation. Today we are going to 
hear from you and others on how our tax laws treat research and 
development and the cost of maintaining a skilled workforce. So 
what I would like to do is turn this over now to our senior 
Democrat on the subcommittee, Mr. Coyne, to introduce the first 
witness.
    Mr. Coyne. Well, thank you, Mr. Chairman, and as you note, 
today is the second of the Oversight Subcommittee's hearings to 
discuss the new economy and whether the tax laws are current in 
today's times. I want to thank Chairman Houghton for scheduling 
these important hearings and also I want to personally welcome 
Mr. Joseph Hester from Pittsburgh, Pennsylvania, who is Vice 
President of Administrative Services at Allegheny Community 
College and will be our first witness on this first panel.
    I look forward to his insights and views on the importance 
of developing and coordinating students' educational studies 
with the workforce skills needed by the business community 
today and to the testimony of the other witnesses, both on the 
first and second panels.
    Thank you, Mr. Chairman.
    Chairman Houghton. Thanks very much, Mr. Coyne. Mr. Weller, 
would you like to make an opening statement?
    Mr. Weller. Well, thank you, Mr. Chairman, and again I want 
to commend you for what I believe are very, very important 
hearings regarding the impact of Federal tax policy on 
technology. Clearly what was stated on Tuesday was that our 
outdated tax code stymies innovation and it is blocking and 
depressing job opportunities and wages for workers. So, clearly 
I think these hearings are extremely important and I look 
forward to discussing with our panel today a couple of 
initiatives that I feel are extremely important and address the 
issue of employer-provided computers and Internet access, as 
well as the need to provide tax incentives for skills training 
in the workforce.
    So, thank you, Mr. Chairman, for the opportunity to 
participate and thank you for putting together these panels.
    Chairman Houghton. Not a bit. Thanks very much, Mr. Weller.
    Now, Mr. Hester, would you begin with your testimony?

 STATEMENT OF J. JOSEPH HESTER, VICE PRESIDENT, ADMINISTRATIVE 
 SERVICES, COMMUNITY COLLEGE OF ALLEGHENY COUNTY, PITTSBURGH, 
                          PENNSYLVANIA

    Mr. Hester. Thank you, Mr. Chairman and members of the 
committee. My name is Joe Hester and I am here representing the 
Community College of Allegheny County. I certainly appreciate 
the opportunity to come and speak to you briefly about the 
Community College of Allegheny County in western Pennsylvania 
and its workforce needs. There is one thing that is clear to us 
in western Pennsylvania and I suspect this is true around the 
rest of the country as well: Today we have more good jobs 
available than we have people that have the skills and training 
and preparation to fill those jobs.
    Our problem is not one of people not having jobs. They have 
jobs, but they also have the aptitude to have better jobs if 
they had the skills and training that they need and there are 
good jobs available for them. Enticing them into the training 
program and giving them that opportunity is the problem that we 
face. The Community College of Allegheny County has been 
involved in a significant way in trying to bridge the gap 
between job demands and the available pool of skilled workers.
    We have programs in place. We have good programs in place 
that could provide those skills. The problem is in attracting 
folks out of the working world and into those training programs 
to acquire those skills. What I am talking about is people who 
can work at the production level in businesses in western 
Pennsylvania. We have institutions in western Pennsylvania that 
do a good job of producing plenty of senior engineers and 
managers to get organizations started and opening them up to 
the public, but we do not have an adequate supply of folks that 
are prepared to work at the production level.
    We have a workforce that could accommodate those 
requirements if they had the necessary training. We think that 
there are a number of options that are available to encourage 
folks to come into our training programs. A prominent one of 
those that I would like to suggest to you is encouragement of 
apprenticeship programs where people are encouraged to go to 
work for organizations and their organizations then provide 
them with the opportunity to go and get instruction in 
technical fields while they are learning also on the job.
    Such programs would allow people the opportunity then to 
learn on the job and to fill those jobs without walking away 
from gainful employment that puts food on the table for their 
families. Section 127 of the Tax Code already provides some 
incentives to businesses to pay for ongoing training for their 
existing employees and we think that is a very positive 
provision. We would like to see it made a permanent provision 
rather than being continually sunset-reviewed.
    I would like to offer a program that we are familiar with 
from Iowa that might be a model that would be useful in 
encouraging businesses to become more involved in providing 
this kind of opportunity to their employees. In that program, 
the community colleges in Iowa are allowed to sell bonds which 
they then use to finance programs for new and expanding 
businesses. The taxes paid by those employees in those new and 
expanded businesses then are funneled back to the community 
colleges for a period to pay off those bonds.
    The Iowa experience has been very positive in the use of 
this kind of vehicle and it is one that I would recommend to 
the committee for consideration. With respect to existing tax 
law, the Hope Scholarship program is a very positive force in 
allowing folks to access the educational programs and advance 
their skills, but it only covers tuition and fees. It does not 
address the living needs of folks that go to community 
colleges, who are normally older than the traditional college 
student, who have families to support and who cannot afford to 
walk away from a job that puts bread on the table.
    If the provision of the Hope scholarship and similar kinds 
of programs were extended to cover these kinds of other 
expenses, we think that would be a positive support for 
community college operations.
    Chairman Houghton. Is that it?
    Mr. Hester. That is essentially it for me, sir. Thank you 
for the opportunity.
    [The prepared statement follows:]

Statement of J. Joseph Hester, Vice President, Administrative Services, 
Community College of Allegheny County, Pittsburgh, Pennsylvania

    Mr. Chairman and Members of the Subcommittee:
    Good morning. My name is Joe Hester and I am Vice President 
for Administrative Services of the Community College of 
Allegheny County (CCAC), located in Southwest Pennsylvania. I 
am pleased to be here to speak with you today.
    In Southwest Pennsylvania, as elsewhere, there are today 
more good jobs available than there are qualified applicants to 
fill them. This is particularly true at the production level 
for many organizations attempting to expand delivery of their 
products or services to expanding markets of opportunity.
    Community colleges have as a significant part of their 
common mission the provision of assistance to their community's 
labor pool in acquiring the necessary knowledge and skills to 
fill these good jobs. If we fail in this endeavor, many good 
jobs in our communities will go elsewhere.
    The Community College of Allegheny County devotes 
considerable energy and effort to assisting the match between 
available jobs and labor market skills. We offer a wide range 
of programs that address the needs that we know about in our 
market area. We work closely with business, industry and labor 
organizations in the area to identify existing and emerging 
requirements. We know, nonetheless, that there are many 
individuals in the area who could benefit substantially from 
participation in our programs but who fail to do so due to some 
set of reasons unique to their individual circumstances. At the 
same time, the needs of business go unmet.
    There are a number of issues that we would encourage you to 
consider in your review of the tax code.

Technology Needs

    Community colleges have long been leaders in the use of 
technology, both for distance learning and in the classroom. 
However, community colleges remain challenged by the ever-
increasing pace of technological development because of the 
drain it puts on resources. As technology develops at a faster 
pace, so do the demands of financing it.
    We urge Congress to develop creative ways of using the tax 
code to help underwrite technology on our campuses. The needs 
are enormous and growing. Perhaps a credit could be established 
to businesses that provide to campuses badly needed 
instrumentation, computers and software, and help with 
infrastructure needs.
    Another approach might be to give states greater incentives 
to make technology available on community college campuses.

Faculty Needs

    Another pressing need at our institutions is faculty adept 
in high-tech areas, particularly those in the area of 
information technology. The fundamental economic reality today 
is that most community colleges simply cannot afford to compete 
in the market for individuals accomplished in IT fields. 
Consequently, a tax credit is needed to encourage companies 
with employees who can teach in the high-tech areas, and the 
natural sciences, to lend them out to institutions of higher 
education. Some businesses are already doing this, but a 
financial incentive would stimulate greater activity and 
benefit all parties over the long run.

Skilled Workers

    Community colleges embrace the goal of working closely with 
business to train workers for the new economy. One pressing 
need remains identifying entry-level workers who have the 
literacy and quantitative skills, and a strong orientation to 
the world of work, to make them productive employees. To help 
companies develop skilled workers, the federal government 
should approve a corporate tax credit to encourage 
participation in early formal training or apprenticeship 
programs. Apprenticeships are beneficial to worker and employer 
alike, but they are extremely costly and easily eschewed in a 
competitive business environment. The government needs to do 
more to tangibly encourage them. To help incumbent workers 
update their skills throughout their careers, a long-time 
priority for CCAC and most community colleges, the federal 
government should provide employers a corporate tax credit of 
$2,500 per employee per year to cover the cost of formal 
training for front-line, hourly wage workers in technical 
fields.

President Clinton's ``College Opportunity Tax Cut'' (COTC)

    Although the tax code is not generally an effective 
mechanism for helping financially disadvantaged students make 
the leap to college, it can, when used creatively, provide 
meaningful access. However, we have deep concerns regarding the 
President's $30 billion ``College Opportunity'' tax plan. While 
the plan provides some benefit to community college students 
wanting to enhance their job-related skills, its basic 
structure precludes it from being of any assistance to needy 
credit students attending community colleges. There are two 
reasons for this:
     As with the Hope Scholarship and Lifetime Learning 
Tax Credits, the President's proposal is non-refundable and 
therefore does not reach low-income students with the greatest 
financial need. We acknowledge the extreme difficulties faced 
by middle and upper middle-income families facing expensive 
tuition bills for higher education. Nevertheless, it is poor 
public policy to address this need to the exclusion of the most 
economically disadvantaged group of college students.
     As with the Hope and the Lifetime Learning 
credits, the newly proposed benefit applies only to tuition and 
fees and does not cover books or living expenses. These costs 
are often as severe an impediment to college attendance as 
tuition and fees, and their exclusion from the credit makes it 
fundamentally flawed.
    The Hope and Lifetime Learning credits have made attending 
the first two years of college more affordable for many, but, 
contrary to what the Administration has asserted, they have 
hardly made the first two years of college affordable for all. 
There is still tremendous unmet financial need for many 
community college students. The Hope and Lifetime Learning 
credits only cover expenses for tuition and fees and are not 
available to the neediest students. If Congress acts on the 
President's new proposal, more must be done to help these 
deserving students.

Section 127 of the Internal Revenue Code

    Community colleges and their students strongly support 
making Section 127 of the Internal Revenue Code permanent. This 
provision has been remarkably successful in helping individuals 
gain access to the education and training so critically 
important to remaining marketable in today's rapidly changing 
economy. As this Committee knows, Section 127 allows employees 
to receive up to $5,250 annually of tax-free employer-provided 
educational assistance. It is effectively targeted because 
businesses have a strong self-interest in making sure that the 
education and training benefits they provide will actually 
result in more productive employees. Section 127 benefits are 
used at all types of institutions of higher education.
    Since its creation, Section 127 has always been subject to 
a sunset provision. It is hard to explain why this should be 
the case, since the provision has strong bi-partisan, bi-
cameral support. Section 127 should be made permanent.
    On behalf of the Community College of Allegheny County, I'd 
like to thank you for the opportunity to appear here today.
      

                                


    Chairman Houghton. Well, thank you very much. We will have 
questions and you can come back and make any other statements 
you would like.
    I would like to move next to an individual, Mr. Bean. 
Thanks very much for coming.

  STATEMENT OF MARTIN BEAN, PRESIDENT, PROMETRIC, BALTIMORE, 
    MARYLAND, ON BEHALF OF TECHNOLOGY WORKFORCE COALITION, 
                      ARLINGTON, VIRGINIA

    Mr. Bean. Mr. Chairman and distinguished representatives, 
my name is Martin Bean and I am President of Prometric, Inc., a 
Thomson Learning company. Prometric is the global leader in the 
delivery of computer-based testing services for academic and 
corporate assessment. And more importantly for today, we are 
the leader in the delivery of IT certification tests where 
every year we deliver over three-and-a-half million exams. But 
perhaps more importantly we touched just about every IT 
professional in the world seeking to be certified in our 
industry.
    I am here today to speak on behalf of Prometric, but also 
the Technology Workforce Coalition, or TWC. TWC was formed to 
address the IT skilled worker shortage, a critical problem in 
every sector of our economy. Nearly 270,000 unfilled positions 
were identified in last fall's workforce study, ``The Crisis in 
IT Service and Support.'' The survey of 878 chief information 
officers and other IT executives found that nearly 10 percent 
of IT service and support professional positions are unfilled 
in America today. As a result, the U.S. economy loses more than 
$100 billion in spending each year on salaries and training. 
The Technology Workforce Coalition advocates Federal-and State-
level solutions to address the shortage, including IT training 
tax credits, H1B visas, temporary visas, K-12 curriculum 
changes and teacher training incentives.
    While TWC supports a multifaceted approach, it believes 
that IT training credits and tax credits would have the 
greatest impact on the shortage. One of the biggest barriers to 
IT training is the cost. Small businesses and individuals often 
cannot afford the cost of training and, more importantly in the 
IT industry, continuous retraining. IT training tax credits are 
market-driven, prudent, cost-effective and user-friendly. For 
that reason, nine members of the U.S. House of Representatives, 
led by Representatives Jerry Weller and Jim Moran, and we thank 
them for that, introduced bipartisan legislation, H.R. 5004, 
the Technology Education and Training Act, on July 27, 2000.
    TWC strongly believes that the provisions of H.R. 5004 
represent the best opportunity defined by the medium-and long-
term solution to the IT worker shortage. The IT training tax 
credit was included on the list of recommendations by the 21st 
Century Workforce Commission. As this session of Congress comes 
to a close, it would be a strong signal to American workers 
that Congress cares about the biggest obstacle to a rewarding 
IT career, namely getting access to the necessary training and 
certification that opens the door to the new economy.
    Federal legislators also play a key role in determining a 
critical but small supply of IT workers that get into the U.S. 
through the INS H1B temporary visa program. In fact, I used the 
INS visa program to come over to the United States from 
Australia. But although H1B workers fill a critical role in the 
IT workforce, the proposed increase in visas will not come 
close to filling over 850,000 available positions in United 
States of America today. Therefore, while it is extremely 
important that we increase access to foreign IT skilled 
workers, we must also focus on training more IT workers here in 
the United States. In doing so, we will silence critics who 
claim the IT industry and Congress is more interested in 
importing temporary foreign workers than it is in training U.S. 
workers.
    If business is changing substantially, and it is, shouldn't 
we also view training in a new way? TWC believes the training 
program must result in certification. IT certification provides 
an independent assessment of the worker skills and helps 
determine whether they are qualified for the requirements of 
the job. Further, it helps ensure that the Government 
investment in training results in the skills truly being 
obtained.
    We understand that time is short here at the end of the 
106th Congress, but by linking the IT training tax credit to 
the H1B visa legislation, Congress can pass two measures that 
will significantly reduce the IT worker shortage, implement two 
recommendations of the congressionally-created 21st Century 
Workforce Commission, silence critics who claim Congress is 
only focusing on foreign workers and encourage more IT training 
for American workers.
    TWC believes that there will be a substantial return on 
investment on the IT training tax credit. U.S. productivity 
would improve and the Government would quickly recover the cost 
of the credits through new corporate sales and personal income 
tax revenue by filling hundreds of thousands of available jobs. 
In 2020, we will look back at this period and recognize that 
either America maintained or lost its position as the global 
leader due to its ability to increase the IT workforce.
    The initiatives I have mentioned today are a win-win for 
all involved as we prepare for the workforce challenges of the 
21st century and strive to maintain America's global IT 
leadership. We thank you, Mr. Chairman, for the opportunity to 
testify at this hearing.
    [The prepared statement follows:]

Statement of Martin Bean, President, Prometric, Baltimore, Maryland, on 
behalf of Technology Workforce Coalition, Arlington, Virginia

    Mr. Chairman and distinguished representatives, my name is 
Martin Bean. I am the president of Prometric, a global leader 
in the delivery of computer-based testing and assessment 
services for academic and corporate assessment, and information 
technology (IT) industry certification. Prometric is a division 
of Thomson Learning, which is among the largest providers of 
lifelong learning. To give you an idea of the scope of our 
business, which is based in Baltimore, Maryland, Prometric has 
contracts to deliver over 2,400 different tests, through a 
network of over 3500 computer-based testing services centers, 
in 128 countries. We operate 10 call centers in 9 countries 
that handled over 7.5 million calls in 1999, operated in 25 
different languages, and handled over 33 different currencies. 
In short, we touch nearly every IT professional in the world 
that wants to be certified for an IT career.
    I am here today to testify on behalf of Prometric and the 
Technology Workforce Coalition (TWC), which was formed to 
address the IT skilled worker shortage. The coalition is made 
up of many IT associations including the Computing Technology 
Industry Association (CompTIA), Information Technology Training 
Association (ITTA), Association for Competitive Technology, 
Association for Online Professionals, American Society for 
Training & Development, Information Technology Association of 
America (ITAA), Software and Information Industry Association, 
Society for Information Management, and over 500 small and 
large companies. Large company members of TWC include my 
company as well as Compaq, Computer Associates, EDS, Ernst & 
Young, Gateway, Global Knowledge Network, Inacom, Intel, 
Lucent, MicroAge, Microsoft, Motorola, New Horizons, Novell, 
Productivity Point Int'l, and Texas Instruments. TWC also has 
hundreds of small company members from all across America.
    As you are well aware, the demand for IT skilled workers 
has caused a major shortage and is a critical problem for large 
and small companies in every sector. This April, ITAA released 
a study showing that over 850,000 of the 1.6 million new IT 
jobs needed in America over the next year can't be filled. 
Nearly 270,000 unfilled positions were identified in last 
fall's ``Workforce Study: The Crisis in IT Service and 
Support.'' Commissioned by CompTIA, the Workforce Study is 
significant in that it focuses specifically on IT service and 
support positions. These workers are responsible for the 
installation, maintenance and repair of computer hardware, 
software, and local area networks, creating websites, as well 
as the help desk support that are critical to customer service 
operations. It is the point of entry into a bright future as 
part of the IT workforce, including thousands of minority and 
disadvantaged students, and displaced workers. The survey of 
878 Chief Information Officers and other IT executives found 
that nearly 10% of IT service and support positions are 
unfilled. As a result, the U.S. economy loses more than $100 
billion in spending each year on salaries and training.
    By 2002, the U.S. Department of Labor estimates that over 
half of U.S. workers will require some type of IT skills 
training. What was once only a worker shortage for IT companies 
has spread to the IT-enabled companies (banking, insurance, 
etc.) throughout the entire economy. According to the Bureau of 
Labor Statistics, more than 20 separate non-IT industries have 
workforces comprised of between 4% and 12% of IT workers. In 
fact, in your own offices you can see the substantial changes 
IT has had on your constituent activities. For better and at 
times for worse, your staff receives hundreds of emails a day. 
Depending on the issue or public interest, the number of emails 
can jump to tens of thousands per office per week. What is 
today a significant challenge for corporate human resource 
departments will soon be a crisis for the public sector since 
they are not able to offer the compensation packages that are 
attracting high tech professionals to careers in the private 
sector. To be blunt, how will state and local governments 
across America attract the IT workforce they need if the public 
and private sectors do not aggressively begin implementing 
solutions to the overall IT worker shortage?
    The Technology Workforce Coalition advocates federal and 
state level solutions to address the shortage including IT 
training tax credits, H-1B temporary visas, K-12 curriculum 
changes, and teacher training incentives. While TWC supports a 
multi-faceted approach, it believes that IT training tax 
credits would have the greatest impact on the shortage. One of 
the biggest barriers to IT training is the cost. Small 
businesses and individuals often cannot afford the cost of the 
training and continuous retraining. IT training tax credits are 
market-driven, prudent, cost-effective, and user-friendly tool 
that will simultaneously help large segments of America's 
workforce including high school students not going to college, 
displaced workers, those caught in the digital divide, and 
people feeling trapped in Old Economy jobs.
    For that reason, nine members of the U.S. House of 
Representatives, led by Representatives Jerry Weller and Jim 
Moran, introduced bipartisan legislation, H.R. 5004, the 
Technology Education and Training Act (TETA), on July 27, 2000. 
H.R. 5004 would offer businesses and individuals in the United 
States the incentives to seek education and training in IT 
industries. TWC strongly believes that the provisions of H.R. 
5004 represent the best opportunity to find both a medium and 
long-term solution to the IT worker shortage and ultimately 
provide U.S. citizens with high paying jobs here at home.
    The coalition thanks Representatives Weller and Moran, and 
the other legislators, for introducing a bill that could have 
the greatest impact on the biggest challenge for today's 
business leaders--hiring, training, and retaining IT workers. 
TETA provides a $1,500 tax credit for information technology 
(IT) training expenses. The tax credit would be available to 
both individuals and businesses. The allowed credit would be 
$2,000 for businesses or individuals in enterprise zones, 
empowerment zones, and other qualified areas. The training 
program must result in certification. This helps ensure that 
the government investment in training has an independent 
assessment built in to verify that the skills are attained.
    The IT training tax credit was included on the list of 
recommendations by the 21st Century Workforce Commission. The 
commission was created by the Workforce Investment Act (WIA) to 
study and recommend solutions to the critical IT worker 
shortage facing America. As this session of Congress comes to a 
close, it would be a strong signal to America's workers that 
Congress cares about the biggest obstacle to a rewarding IT 
career--getting access to the necessary training and 
certification that opens the door to the New Economy.
    Federal legislators also play a key role in determining a 
critical but small supply of IT workers that enter the U.S. 
through the INS H-1B Temporary Visa program. H-1B workers fill 
high-end IT positions when American workers are not available. 
In fact, I used an INS visa program to come over to the United 
States. I serve as an example of the typical foreign worker 
that is given the opportunity to participate in the greatest 
economy the world has ever seen. America is the land of hopes 
and dreams to millions of people across the globe. After 
getting a chance to work in America, highly educated H-1Bs 
often move into positions where they are responsible for 
hundreds of workers or in my case, get the chance to run an 
entire company. America also benefits tremendously by 
attracting the best minds throughout the globe that are given 
the opportunity to taste the American dream, flourish in its 
system, and create opportunities for thousands of American 
workers. From the immigrants fleeing tyranny over the last 200 
years to the foreign skilled IT workers seeking a seat in the 
lead engine of the New Economy, America continues to offer 
hope, riches, and a chance for every person willing to work 
hard to achieve their American dream.
    Several legislative proposals have been put forward 
recently that would increase the number of H-1B visas. In 2020, 
we will look back at this period and recognize that America 
either maintained or lost its position as the global IT leader 
due to its ability to increase its IT workforce. By attracting 
the best minds from other countries and improving our domestic 
education and training programs at all levels, America can win 
the IT talent competition.
    But although H-1B workers fill a critical role in the IT 
workforce, the proposed increase in H-1B visas will not come 
close to filling over 850,000 available positions. In fact, for 
the next 10 years, over 80% of the IT workforce must come from 
the existing labor pool, which calls substantially for a strong 
investment in re-training American workers. Therefore, while it 
is extremely important that we work to increase access to 
foreign IT skilled workers by increasing the cap on H-1B visas, 
we must also focus on training more IT workers here in the 
United States. We can also silence critics who claim the IT 
industry and Congress is more interested in importing temporary 
foreign H-1B workers than it is in training U.S. workers. 
Passing H.R. 5004 will enable Congress to silence H-1B critics 
by simultaneously taking steps to increase the training of U.S. 
workers.
    Tax credits are an efficient way to deliver incentives to 
small businesses, which typically are unable to afford the high 
costs of IT training and lack the manpower to keep up with the 
paperwork required to qualify for other programs. The tax 
credit would be increased to $2,000 for all companies operating 
in enterprise or empowerment zones, and for companies with 
fewer than 200 employees. Since those receiving training will 
find jobs waiting for them when they finish their training, the 
country will immediately begin recouping its investment in the 
form of additional personal and corporate income taxes that 
would otherwise not be generated.
    One of the most important aspects to our new economy is how 
rapidly business practices and the IT skills required for 
workers change. IT training tax credits let business leaders 
dictate who, what, and where to train. Congressman Jim Moran 
represents the 8th district of Virginia. He sums up the problem 
at the federal job training level quite well. ``Unfortunately, 
some federal job training programs are training workers how to 
use an abacus. They just aren't prepared to train the workforce 
of today or tomorrow.''
    IT is changing every business sector and the terminology 
that details our work (i.e., 24x7, bandwidth, and e-anything). 
In fact, Intel's Chairman Emeritus Andy Grove stated recently 
that, ``Within the next 5 years, every business will be an E-
business or be Out-of-Business.'' If business is changing 
substantially, shouldn't we also view training in a new way? 
Business leaders are very skeptical regarding the reliability 
of IT workers that say they have received training, but are not 
certified. An independent assessment of the workers skills best 
determines whether they are qualified for the requirements of 
the job. Another consideration is that students seeking IT 
careers have often been misled into believing that by just 
taking an IT course they are guaranteed to get a job. Many 
business organizations are calling for wide scale use of IT 
certifications to provide fundamental skill assessments that 
will benefit both the employer and the worker.
    Another unfortunate result of the IT worker shortage is 
that human resource managers are now looking at high schools 
and colleges as high tech recruiting centers. That would be 
great if these recruiters were focusing only on the students, 
but the IT worker shortage is so critical that teachers are 
getting great offers to make the school to work transition 
America doesn't want. We should not blame teachers. They get 
offers to double their salary, use the latest hardware and 
software, and have the opportunity to earn substantial stock 
options and bonuses. If America is to obtain the long-term 
return from its investment in school systems that will be 
required in the New Economy, then principals and politicians 
must realize--especially in a strong economy--that schools are 
competing with start-ups and established companies for workers 
with IT skills. The only way to reduce the demand on 
transitioning teachers to IT workers is to increase the number 
of IT trained workers.
    By implementing these solutions to the critical IT skilled 
worker shortage, America will stimulate employment of new and 
displaced workers into high-paying IT careers, fill critical 
and growing IT labor shortages across all industries, and 
strengthen the U.S. economy by enhancing productivity and 
increasing exports. The initiatives I have mentioned today are 
a win-win for all involved as we prepare for the workforce 
challenges of the 21st century and strive to maintain America's 
global IT leadership.
    We understand that time is short here at the end of the 
106th Congress. But by linking the IT training tax credit to 
the H-1B visa legislation, Congress can pass two measures that 
will significantly reduce the IT worker shortage, implement two 
recommendations of the congressionally created 21st Century 
Workforce Commission, silence critics who claim Congress is 
only focusing on foreign workers, and encourage more IT 
training for American workers. TWC believes that there will be 
a substantial ROI on the IT training tax credit. U.S. 
productivity would improve and the government would quickly 
recover the cost of the credits through new corporate, sales, 
and personal income tax revenue by filling hundreds of 
thousands of available jobs.
    We thank you Mr. Chairman for the opportunity to testify at 
this hearing. TWC would be happy to provide you with any 
further information you desire about federal and state efforts 
to address the IT skilled worker shortage. We encourage all 
interested parties to visit our Web site, 
www.techcoalition.org, to see detailed information about the 
shortage and how they can join the grassroots effort to help 
implement the solutions discussed today.
      

                                


    Chairman Houghton. Thank you very much, Mr. Bean.
    Mr. Salamon?

  STATEMENT OF MITCHELL SALAMON, SENIOR TAX COUNSEL, AMERICAN 
               AIRLINES, INC., FORT WORTH, TEXAS

    Mr. Salamon. Thank you, Mr. Chairman. Good morning, Mr. 
Chairman and members of the subcommittee. My name is Mitchell 
Salamon, and I am Senior Tax Counsel with American Airlines in 
Fort Worth, Texas. American Airlines appreciates the 
opportunity to address the important role of Federal tax law in 
the new economy. Specifically, we want to tell you about an 
exciting new program we are implementing to help our employees 
bridge the digital divide. And most importantly, we are here to 
urge you to pass H.R. 4274, which will greatly enhances this 
process. I would like to take this opportunity to thank Mr. 
Weller and Mr. Lewis for their leadership in this area.
    Earlier this year, American Airlines and American Eagle 
joined the ranks of Ford Motor Company, Delta Air Lines and 
Intel by announcing that we would implement an employer-
subsidized, home computer initiative for our workforce. Under 
our program, American will subsidize employee purchases of 
basic home computers with unlimited Internet access. We 
anticipate spending over $45 million over the next three years 
to put home computers into the hands of every employee who 
chooses to participate.
    American's home computer program is an employee-empowerment 
initiative that also makes business sense. Computer skills are 
an essential component of almost every function within the 
airline industry. American Airlines and American Eagle operate 
and maintain 970 aircraft serving 243 cities with 4,100 daily 
departures throughout the world. Today I am delighted to have 
with me Crew Chief Thomas Thompson, representing our workforce.
    In light of the scope and complexity of our industry, you 
can see that a technically-skilled workforce is vitally 
important to our success. As you might expect, we rely heavily 
on advanced technology to run sophisticated reservation, flight 
and revenue management and maintenance systems, which are 
continuously modified and upgraded. Obviously, a workforce 
skilled in tomorrow's technology will contribute greatly to 
American's primary goal of delivering the highest quality 
customer service.
    In addition to supplying the hardware, American is 
developing an Internet portal which will provide an 
unprecedented opportunity to facilitate effective and timely 
communication between the company and its employees on issues 
ranging from company and industry news, corporate policies, 
surveys, safety issues, online training, scheduling flight crew 
assignments, accessing human resource and benefit information, 
and leveraging emerging e-business opportunities that are 
currently under development by the company.
    This year American Airlines also created and introduced 
Flagship University, a virtual institution and library that 
employees can access through the portal. Flagship University 
will deliver employee development programs on topics such as 
airport customer service, handling of dangerous goods, airport 
security, flight service, environmental issues, work balance 
issues, substance abuse and leadership issues that we hope will 
instill knowledge, skills and the attitudes necessary to 
maximize the long-term potential of our employees.
    So far, employee feedback has been overwhelmingly 
enthusiastic and enrollment is high. Participating employees 
pay American $12 per month for three years, but may upgrade and 
obtain options directly through the vendor at their own 
expense. Many employees have acknowledged that they would not 
be able to purchase a computer without the benefit of the 
program. Our employees are seizing this opportunity to enhance 
and develop their computer literacy and, consequently, they 
will be prepared for work assignments and new positions that 
will continue to evolve with the progression of the information 
age.
    However, without a clarification of the tax laws, the 
potential for adverse tax consequences in this instance will be 
a significant impediment to implementing workforce initiatives 
that help close the digital divide. The current tax rules are 
unclear whether employer-subsidized home computers will be 
characterized by the IRS as taxable compensation to employees. 
The potential tax burden will most certainly reduce the number 
of employees taking advantage of this opportunity and other 
employers for making similar investments in their workforce.
    For this reason, we believe it is critical that Congress 
adopt H.R. 4274, the Digital Divide Access to Technology Act, 
the DATA Act, introduced by Congressmen Weller and Lewis. This 
legislation will clarify that employers can provide subsidized 
computers and Internet access to their employees as a non-
taxable fringe benefit, which will further motivate the 
business community to bridge the technology gap that currently 
exists.
    Mr. Chairman, thank you for the opportunity to speak before 
the subcommittee today and I will do my best to answer any 
questions that you or other members may have.
    [The prepared statement follows:]

Statement of Mitchell Salamon, Senior Tax Counsel, American Airlines, 
Inc., Fort Worth, Texas

    Mr. Chairman and members of the Subcommittee, American 
Airlines appreciates the opportunity to address the important 
role of Federal tax law in the ``new economy.'' Specifically, 
we want to tell you about an exciting new program we are 
implementing to help our employees bridge the digital divide. 
And most importantly, we are here to urge you to pass H.R. 
4274, which will greatly enhance this process.
    Earlier this year, American Airlines and American Eagle 
joined the ranks of Ford Motor Company, Delta Airlines and 
Intel by announcing that we would implement an employer-
subsidized home computer initiative for our workforce. Under 
our program, American will subsidize employee purchases of 
basic home computers with unlimited internet access. We 
anticipate spending over $45 million over the next three years 
to put home computers into the hands of every employee that 
chooses to participate.
    American's home computer program is an employee empowerment 
initiative that also makes business sense. Computer skills are 
an essential component of almost every function within the 
airline industry. American Airlines and American Eagle operate 
and maintain 970 aircraft serving 243 cities with 4,100 daily 
departures throughout the world. Together, we employ over 
110,000 people. In light of the scope and complexity of our 
industry, you can see that a technically skilled workforce is 
vitally important to our success. As you might expect, we rely 
heavily on advanced technology to run sophisticated 
reservation, flight and revenue management and maintenance 
systems, which are continuously modified and upgraded. 
Obviously, a workforce skilled in tomorrow's technology will 
contribute greatly to American's primary goal of delivering the 
highest quality customer service.
    In addition to supplying the hardware, American is 
developing an intranet portal, which will provide an 
unprecedented opportunity to facilitate effective and timely 
communication between the company and its employees on issues 
ranging from company and industry news, corporate policies, 
surveys, safety issues, on-line training, scheduling flight 
crew assignments, accessing human resource and benefit 
information, and leveraging emerging e-business opportunities 
currently under development.
    This year American Airlines also created and introduced 
Flagship University, a virtual institution and library that 
employees can access through the portal. Flagship University 
will deliver employee development programs on topics such as 
airport customer service, handling of dangerous goods, airport 
security, flight service, environmental issues, work/life 
balance, substance abuse, and leadership issues that will 
instill knowledge, skills and attitudes necessary to maximize 
the long-term potential of our employees.
    So far, employee feedback has been overwhelmingly 
enthusiastic and enrollment is high. Participating employees 
pay American $12 per month for 3 years and may upgrade and 
obtain options directly through the vendor for an additional 
fee. Many employees have acknowledged that they would not be 
able to purchase a computer without the benefit of the program. 
Our employees are seizing this opportunity to enhance and 
develop their computer literacy, and consequently, they will be 
prepared for work assignments and new positions that will 
continue to evolve with the progression of the information age.
    However, without a clarification of the tax laws, the 
potential for adverse tax consequences will be a significant 
impediment to implementing workforce initiatives that help 
close the digital divide. The current tax rules are unclear 
whether employer-subsidized home computers will be 
characterized by the IRS as taxable compensation to employees. 
The potential tax burden will most certainly reduce the number 
of employees taking advantage of this opportunity and other 
employers from making similar investments in their workforces.
    For this reason, we believe that it is critical that 
Congress adopt H.R. 4274, the Digital Divide Access to 
Technology Act (DATA Act) introduced by Congressmen Weller and 
Lewis. This legislation will clarify that employers can provide 
subsidized computers and internet access to their employee as a 
non-taxable fringe benefit, which will further motivate the 
business community to bridge the technology gap that currently 
exists.
      

                                


    Chairman Houghton. Thanks, Mr. Salamon. I would like to 
turn the proceedings over to Mr. Coyne for some questions.
    Mr. Coyne. Thank you, Mr. Chairman. Mr. Bean, you indicated 
that we have to train more IT workers here in this country as 
opposed to reaching overseas, not that we are going to refrain 
from doing that, but we must begin here at home. I would like 
to know what level of achievement educationally must a 
candidate for this training have already achieved.
    Mr. Bean. Do you mean what level of education prior to 
entering the industry?
    Mr. Coyne. Yes. Right.
    Mr. Bean. Thank you. One of the interesting things about 
our industry is that it is extremely egalitarian. The 
technology changes at such a rapid pace that it has more to do 
with a person's willingness and aptitude to embrace the 
technology and learn how to use it than it does to actually 
have to have reached any particular formal status in our 
education process.
    Many of the certification programs that we sponsor, 
programs such as CompTia's A-Plus program are specifically 
designed to take entry-level workers who often have very 
limited formal education and allow them to take advantage of 
the new economy by giving them the just-in-time, industry 
level, pragmatic training that they need to actually be very 
relevant to our economy, to actually be able to implement the 
technology that is out there.
    So, in short an answer to your question is that more than 
just about any other industry, IT technology relies more on the 
inherent skills, aptitude and desire of the individual than any 
formal level of qualification earned.
    Mr. Coyne. Thank you. Mr. Hester, why aren't enough of our 
students being trained to fill the positions that are now being 
offered to H1B candidates?
    Mr. Hester. Representative Coyne, I think there are a 
number of reasons why they are not. One is that those folks who 
have the aptitude and the abilities necessary to acquire these 
skills are, in today's robust economy, earning a living 
someplace else and they are not prepared to come out of that, 
to come into a training program like Community College of 
Allegheny County operates in order to acquire those skills at 
the loss of their ability to put food on the table.
    One of the ways that we try to address that is to work with 
businesses to have a cooperative arrangement with them--that 
they bring folks that have these kinds of aptitudes, aptitudes 
that we have tested for, into their businesses and begin to 
work and work with us to provide technical training for them, 
to update their skills while they also learn on the job. This 
is an expensive proposition for businesses to engage in and we 
have not developed a tremendous amount of capacity through 
that, but that is one of the reasons why we have not been able 
to fill these needs, because we cannot attract people with the 
necessary aptitude out of already-paying jobs.
    The second is we have difficulty in attracting the 
necessary instructional faculty in these areas. These folks are 
very expensive nowadays. Those that already have the ability to 
work in this marketplace are drawing a very high salary and our 
salary limitations, to some extent, prevent us from attracting 
them into our educational environment to teach. Something that 
would be helpful to us is any kind of mechanism that would make 
it more attractive for businesses to place their employees on 
loan to us for a period of time, to allow us to train--work in 
partnership with them to train those necessary production level 
workers within the salary structure we have to live with.
    Mr. Coyne. Thank you very much. Thank you, Mr. Chairman.
    Chairman Houghton. Thank you, Mr. Coyne. Mr. Weller?
    Mr. Weller. Well, thank you, Mr. Chairman. I think this 
first panel has been very, very helpful as we talk about the 
important role of education and skills training in technology. 
I think one thing I have certainly seen, since this is the 
second part of a two-day set of hearings, is how the Tax Code 
has an impact particularly on global competitiveness as we 
compete with our Asian and European competitors to attract 
technology jobs. Clearly, the Tax Code, as well as our 
investment in education, is going to make a big difference.
    It is interesting when we talk about statistics a lot and 
there are almost 5 million Americans today employed in the 
technology sector. Technology-sector wages are about 70 percent 
higher than the traditional private sector jobs, so there is a 
lot of opportunity. But at the same time, even though there is 
a tremendous number of Americans employed in technology, we are 
having a hard time filling all the positions.
    Mr. Bean, you noted in your testimony, referring to a study 
that was done this past year, that almost one out of 10, 10 
percent of IT worker positions, are unfilled. Currently, almost 
270,000 jobs, right now, are unfilled and it certainly has a 
big impact on our economy with the loss of productivity and 
creativity, as well as worker productivity. That same study, I 
believe you noted, indicated that next year we are going to 
need 1.6 million new workers and that, unless we adjust this 
worker shortage, that half of those jobs will go unfilled. 
Obviously, the H1B visa issue, and of course I am a supporter 
and co-sponsor of David Dreier's bill, is a short-term 
solution.
    But I believe I know, as you do, Mr. Bean, that the long-
term solution is investment in skills training and education. I 
wanted to ask you, Mr. Bean, why is the skills investment so 
important as we look at global competitiveness? You indicated 
your company does certification not only in the United States, 
but in Asia and Europe as well, so you are dealing with our 
competitors. But from an American standpoint, from our own 
parochial interest, why is skills investment so important?
    Mr. Bean. Thank you. I think it was best summed up by 
Chairman Greenspan in his Humphrey Hawkins testimony, where he 
really described what is fueling our economy today, that this 
IT revolution is what is fueling it largely. When we look at 
the magnitude, as you just summed us for us then, Congressman, 
of the shortage that faces us, I do not believe there is any 
other single threat to our competitors on the global stage as 
big as our shortage of IT workers. This industry, as you know, 
is summed up in this hearing and in setting this hearing up, 
used to largely be about the hardware and software in the IT 
industry. But the global stage has shifted.
    The hardware and software now is nowhere near as important 
as what I talk about as the brainware in our industry--that 
those economies that are going to do best in their ability to 
compete on the global stage are not those that have the 
economic wherewithal to invest in the hardware and software, as 
much as those that have their people skilled and educated, to 
be able to translate that at an individual level to an enduring 
competitive advantage, but on the global stage, for America, 
into an enduring competitive advantage.
    The workforce shortage that we have in the IT industry is 
not an American phenomenon, it is a global phenomenon. My fear 
for America is that unless we take steps right now to put the 
training where we need it, to skill the American workers, to 
help the private sector embrace the technology fairly rapidly, 
due to the rate of change of technology, we are going to slip 
behind in our ability to remain the leader in the IT industry, 
something that we should all be very proud of and we should not 
let slip away, because as Chairman Greenspan said, that is what 
is fueling our economy today; that is what will fuel our 
economy going forward and the greatest asset we have in 
remaining competitive on a global stage is our investment in 
our people to embrace that technology.
    Mr. Weller. Well, you testified in support of our 
bipartisan legislation, the Technology Education Training Act, 
which provides a tax incentive to attract investment in skills 
training and investment in people.
    Mr. Bean. Yes.
    Mr. Weller. Why do you believe a tax incentive is the best 
way to encourage this type of investment in skills training and 
solve this problem?
    Mr. Bean. I think it is because it puts the private sector 
in a position to be able to embrace the training that they need 
to remain competitive. It is extremely pragmatic. It is going 
to allow them to, as they have done a pretty good job of in the 
past, adopt those types of education and training programs that 
they need to remain competitive.
    The rate of change in technology is such, as was, I 
thought, very well summed up by my colleague to my right, such 
that you have got to do something different. Formal academic 
institutions cannot keep pace with technology that changes on 
average every six months. It also gives the private sector the 
opportunity, though, to reach out to those workers that, quite 
frankly, want their piece of the new economy.
    You know, if you think about workers needing to cross the 
digital divide, as is characterized by all of us in the various 
pieces of legislation before us, their ability to be able to 
cross that digital divide is largely a function of our ability 
to give them the necessary training that they need to be 
relevant inside the organizations that they work for, both in 
the public and the private sector.
    I believe that the implementation of a tax credit will give 
us and give our economy the ability to put the training spend 
(sic.) where it will do the most for our competitiveness on a 
global level.
    Mr. Weller. Thank you, Mr. Bean. I see, Mr. Chairman, that 
my time has expired. I do have some questions for Mr. Salamon. 
If there is a second round of questions, I would like to ask 
Mr. Salamon questions after my colleagues complete their first 
round of questioning.
    Chairman Houghton. All right. Why don't I cut in here and 
then maybe Ms. Dunn would like to ask a question and then we 
will go around for a second round. The concept of tax credits 
is a dicey one for us because we keep loading up tax credit. 
The President says that we should not use tax credits and then 
all of a sudden we have 28 or 30 or 40 or 50 suggestions as far 
as tax credits and it really complicates the code.
    I can understand, and this is to all of you really, the use 
of tax credits where the incentive is absolutely essential. For 
example, I think, Mr. Hester, you said something about front-
line hourly wage workers in the technical field. I think that 
is probably a pretty good idea. I am just talking for myself. 
When it comes to middle-or upper-management, clearly the 
success of most of these companies in the information 
technology area is that they have training programs themselves.
    They just bite the bullet and they do it, but it doesn't 
get all the way down. So, the question is how far should those 
tax credits go in the organization? Maybe, Mr. Hester, you 
would like to answer it, and Mr. Bean, and also Mr. Salamon, 
just as far as you are concerned, I would like to find out 
really sort of what percentage of the people you think would be 
using these computers, and also would they be used for business 
as well as home use. So, why don't we start with you, Mr. 
Hester?
    Mr. Hester. It is difficult for me to speak to the general 
question of how far up in the organization--that is the way I 
would put it--these kinds of tax credits should extend. Clearly 
from our perspective, from the community college perspective, 
where we are involved in and engaged in trying to fill the 
production-floor level kinds of jobs that are most needed by 
all kinds of industries and where the real shortage of 
personnel exists, it is in attracting those folks into those 
training programs, whether they are inside a corporation or in 
our institutions exclusively, that we think a tax credit would 
be very beneficial.
    Again, there are other incentives that are very attractive 
on a normal kind of personal level for individuals and 
businesses at higher levels of employment to work on 
maintaining and sustaining their skills, but the problem of 
filling available jobs at the production floor level is one 
that we are all struggling with and that requires getting folks 
into the human capital development pool, out of the working 
environment, and we think a tax credit would be very positive 
for them. And certainly, if it didn't extend any farther, we 
would certainly hope you would consider that.
    Chairman Houghton. So, the question is to take the front-
line workers, to get them there and then to keep them there? 
Mr. Bean?
    Mr. Bean. I think the question is best answered at two 
levels. I think in addition to looking at how far down in an 
organization this tax credit should apply to training, but also 
across the industry sectors in terms of the size of the 
companies. By 2002, the U.S. Department of Labor estimates that 
over half of U.S. workers will require some type of IT skills 
training. I actually believe that that is a conservative 
estimate. I think that it will be more than half.
    If you think about that, that means the answer to your 
question, Congressman, is that just about every level in the 
organization should be able to take advantage of IT training. 
The reasons for that are many. If we look at the rate of change 
inside all organizations, not just the IT sector but any 
company that seeks to embrace technology to remain competitive, 
and what we have seen over recent years with the proliferation 
of the Internet through organizations and the ability for every 
worker to tap into the information they need to do their job, I 
think the answer is that every worker of the future needs to be 
able to take advantage of IT training to remain individually 
competitive, but also competitive in the economy.
    Chairman Houghton. No, I agree. It is just that the 
question is how far down does the Government get into the 
process?
    Mr. Bean. Sorry. How far down does the Government get into 
the process of the tax credit? I think that the more flexible 
that we can be in actually allowing organizations to make the 
decisions of what IT training they need to be competitive is 
the right answer to that question. I think the more broad-
ranging we can be with the tax credit to allow the money to be 
put where it is going to be of greatest advantage is where we 
need to head.
    Chairman Houghton. Thanks very much. Mr. Salamon?
    Mr. Salamon. Thank you, Mr. Chairman. In response to your 
question, so far we have distributed about 40 percent of the 
enrollment kits to our workforce. So, in essence, 40 percent of 
the workforce now has the ability to enroll in the program. 
Sign-ups at this point have been about 70-to-80 percent and we 
contemplate that upwards of 90 percent of eligible participants 
are going to take advantage of this program. It has been met 
with a lot of enthusiasm.
    These computers will be used at home. They will be used 
outside the workplace. From our standpoint, clearly there is 
going to be some personal benefit here, but the compelling 
business motivations for us to do this clearly outweigh any 
personal benefit that employees might have.
    Chairman Houghton. They would probably be used at home and 
not in the business place.
    Mr. Salamon. Not in the business place itself.
    Chairman Houghton. Thanks very much. Ms. Dunn, would you 
like to ask questions?
    Ms. Dunn. Thank you very much, Mr. Chairman.
    Mr. Bean, you talked about the certification process. Could 
you explain the certification process to us? If you are 
certified in one State, are you automatically certified in 
another State?
    Mr. Bean. Thank you for the question. Yes, the 
certification process is actually one of the truly portable 
qualifications in the world, in the IT industry, which is what 
we are speaking about specifically today. The test that 
somebody would pass in my State of Maryland versus the test 
that somebody would pass in California, because it is all 
delivered via a computer, is exactly the same. And so the 
qualification itself is not only transportable across States, 
but also national frontiers, as well.
    Ms. Dunn. Would you just run through what it involves?
    Mr. Bean. Sure. The process is largely the combination of 
learning and then testing, the certification really being the 
outcome of the learning. The way an individual can learn to be 
qualified to take an IT certification is very laissez-faire. 
You can learn either through self-study on the job, by 
attending formal classroom training, attending Web-based online 
learning and the certification exam itself, which takes place 
in a secure testing center on a computer terminal that asks you 
a series of questions that are simulation-based, multiple-
choice, true-false, scenario-driven, are then the final outcome 
on which the certification is granted by either the industry 
association such as CompTia, or for that matter vendors such as 
Microsoft, Novell, Computer Associates, et cetera.
    Ms. Dunn. Also, Mr. Bean, could you tell us, is the worker 
training credit in place of Section 127 or is that in addition 
to Section 127?
    Mr. Bean. Thank you. Sorry for having to check. It is in 
addition, ma'am.
    Ms. Dunn. Thank you very much.
    Chairman Houghton. Mr. Weller?
    Mr. Weller. Thank you, Mr. Chairman. Thank you for the 
courtesy or the opportunity to do a second round of 
questioning. I would like to direct a few questions to you, Mr. 
Salamon. There are always interesting statistics. You have 100 
million Americans today that are online. Seven million 
Americans go online for the first time every second and so 
there is a tremendous opportunity for working Americans to gain 
information and participate in the new economy in many ways.
    But if you look at other statistics you note that 
households with incomes of 75,000 or more are 20 times more 
likely to have a computer or Internet access at home. Educators 
tell me they notice the difference in the classroom between 
kids who have a computer and Internet access at home and those 
who do not and the ability of children to do their homework and 
schoolwork and do work on a school paper. And that is why I 
really want to salute American Airlines, as well as Ford, Intel 
and Delta Airlines, for stepping forward in providing computers 
and Internet access is a solution to that challenge. That is 
600,000 families as a result of your company and three others.
    I know with Ford Motor Company, almost 5,000 families in my 
district will benefit from what Ford Motor Company is doing. 
But, as a result of your initiative, everyone from the laborer, 
the assembly-line worker, the baggage handler, the flight 
attendant, all the way up through management, their children 
will now have computers and Internet access at home to do their 
homework, and that is why I want to thank you for your 
company's leadership in doing this.
    I also want to thank you for bringing one of your fine 
workers with you, Tom Thompson, who I understand is employed 
out at Dulles airport. You do a great job. I have flown in and 
out of there on American Airlines and appreciate the good work 
you do as an example of an employee that would benefit. It is 
my understanding that unless our legislation is passed and 
signed into law, the IRS could impose a tax on workers for 
receiving employer-provided computers and Internet access.
    Our estimates from our staff analysis would estimate that a 
worker making about $27,000 a year would pay about $200 in 
taxes if they choose to accept these computers and Internet 
access. And, for a worker making 27,000, 200 bucks is a lot of 
money. It is real money for working people. Mr. Salamon, let me 
just ask a few basic questions of you. Tell me how many 
American Airlines employees have actually received computers as 
a result of your initiative. I know you have indicated you are 
going through the sign-up process. Are they actually receiving 
computers and Internet access in their home at this time?
    Mr. Salamon. Many of the employees that have signed up 
receive it within the same week. Forty percent of the workforce 
now has the forms to sign up and it is going like gangbusters. 
There is a six-month window really to sign up, but the reaction 
up front has just been tremendous. The phones are ringing off 
the hook.
    Mr. Weller. So, there is a lot of enthusiasm. Because of 
this tax issue, I know I had spoken with one of your other 
employees and they said there is a little bit of buzz among the 
employees. They had heard the Department of Treasury, the IRS, 
may tax their computer benefits. Have you had concerns 
expressed to you by employees?
    Mr. Salamon. Yes, sir. In our focus groups, that was a 
concern that was discussed right up front as we mentioned the 
possibility of a tax on distributing the computers, and the 
indications from them were that they would have to take that 
into account in whether or not this was something they want to 
participate in or whether they really could afford to.
    Mr. Weller. Have employees expressed hesitancy, been 
hesitant about accepting these computers because a worker 
making $27,000 would have to pay $200 in taxes? Have some said 
they would probably not accept it because of that concern for 
the taxes?
    Mr. Salamon. In our original focus groups, that was a 
concern.
    Mr. Weller. Have you had other companies that have 
expressed interest in providing this type of benefit to their 
employees? Have they consulted with you about potentially doing 
this and expressing concern regarding this potential tax 
consequence?
    Mr. Salamon. Yes, Mr. Weller, aside from the companies that 
you mentioned, we have been contacted by three or four 
companies that are exploring this as a possibility and also are 
concerned about the tax issue and wanted to consult with us on 
where we were on the tax issue.
    Mr. Weller. Of course, one of the initiatives when 
Representative Lewis and I joined together to offer this 
bipartisan legislation to clarify the tax treatment of 
employer-provided computers and Internet access--of course, we 
would like to see it treated the same as an employer 
contribution to a pension benefit or an employer contribution 
to a health care benefit. And we believe it is good policy to 
eliminate the digital divide and, of course, because of your 
company's leadership and the others that are moving forward on 
this, we now have an opportunity essentially for universal 
access for every working American that is employed by American 
Airlines or other companies, to have access to the Internet 
and, of course, the opportunity that it provides.
    From an, essentially, if I can use the term, quality-
control standpoint, what type of conditions do you have for the 
employees on their ability to use these computers to ensure the 
computer stays in the home and doesn't wander off, if the 
employee is terminated or decides to leave their position? What 
types of controls do you have?
    Mr. Salamon. The way we are implementing our program, and 
each program obviously is going to be different, but the way 
American's program works is the computers are theirs. There is 
a significant co-payment that they are making in their 
participation in the program. The computers are theirs. We 
anticipate that they are going to make good use of the 
computers. There will be some personal use. Clearly there is 
going to be business use that is going to benefit both them and 
us in the long run.
    In terms of other controls, we have the policies in place 
about responsible behavior with computers, but there is no 
monitoring going on. We have a lot of trust in the workforce. 
This is an initiative of faith that really is for their benefit 
in the long run and we trust that they will use it 
appropriately.
    Mr. Weller. Just a final quick question. Would these 
employees be able to use these computers obviously to access 
their employee benefits, see where their pension is or if they 
have questions regarding their health benefits? Is that the 
type of use that they could use them for?
    Mr. Salamon. That is absolutely part of the game plan. They 
will have a whole host of information available right through 
our Internet site. They will be able to customize their own 
personal Internet site for workforce information that is 
particularly relevant to them and they will have continuous 
access and it will be a great way for us to communicate back 
and forth very effectively.
    Mr. Weller. Thank you, Mr. Salamon, and thank you for 
bringing Tom Thompson, one of your workers from Dulles airport 
with you today, too, as well. But thank you for your time in 
participating. Mr. Chairman, thank you.
    Chairman Houghton. Thank you very much. Ms. Dunn?
    Ms. Dunn. I think we have got an outstanding panel here and 
I want to take advantage of your creativity by asking you a 
question that is very basic to a lot of us in the Congress now. 
In the last couple days, we have read about the number of 
teachers that are going to be retiring over the next few years 
and, at the same time, we have read a lot about baby boomers 
with technology backgrounds who are thinking about taking early 
retirement to do something else. I am a former IBM systems 
engineer. What kind of tax incentives and educational 
incentives would you like to see or would be effective in 
recruiting people with technology backgrounds to go into 
teaching so that they can truly develop a group of young 
educated people who will be able to have good technology skills 
as they graduate from high school college? Any thoughts?
    Chairman Houghton. Don't all speak at once.
    Mr. Bean. It is a very good question, and obviously the 
teacher shortage is, from an educational perspective and as a 
parent, is going to be a significant challenge for all of us on 
a global stage when we just talk about broad learning 
competitiveness, as well. As I sit here as somebody like you, 
who came up through the IT education industry, in the IT 
industry, I think what would take for me to be up to go back 
and do that--I think the types of incentives that are going to 
be important is firstly a recognition, as it was summed up 
before, that when you look at the delta that exists between 
what is paid to our teachers in the IT arena to actually impart 
those skills versus what is earned in the private sector, I 
think there is going to have to be something done for teachers 
just to stay in place. For those that aren't looking to leave 
their particular profession, what are we going to do for them 
to actually stay in place as teachers rather than to be poached 
by HR managers looking to fill their depleted ranks inside 
corporate America, as well? So, in terms of tapping into the 
creativity today, I would say we need to first of all address 
the incentives for the teachers to stay put, and I hate to say 
it, but I can only think that thing has to start with economic 
incentives, given the disparity that exists between what IT 
teachers are paid versus what they can earn in the private 
sector by moving into system engineer-type roles.
    Secondly, to attract those people back into teaching, which 
I think is something that many of them would be extremely 
interested in doing, what we need to take a look at is to make 
sure that our taxation system does not unduly penalize them for 
wanting to impart those skills to young people or people of all 
levels. So, instead of necessarily putting incentives in place, 
let's revisit our taxation system to make sure that if you or I 
sought at our point of retirement, which these days can be in 
our early 40s in the IT industry, that we are not penalized for 
wanting to go back into the school system and actually give of 
our expertise to young people so that they can move forward.
    Chairman Houghton. All right. Fine. Well, gentlemen, thanks 
very much. You have been very, very helpful. I would like to 
call the second panel. Bill Sample, Chairman of the R&D Credit 
Coalition, Redmond, Washington, Senior Director of Domestic 
Taxes and Tax Affairs for Microsoft; and Mr. Randall Capps, 
Corporate Tax Director and General Counsel, Electronic Data 
Systems Corporation; Linda Evans, Program Director of Taxes and 
Finance, Governmental Programs, IBM; and Collie Hutter, Chief 
Operating Officer of Click Bond, Inc., of Carson City, Nevada.
    Well, thank you very much for being with us. Mr. Sample, 
would you begin your testimony?

   STATEMENT OF BILL SAMPLE, CHAIRMAN, R&D CREDIT COALITION, 
 REDMOND, WASHINGTON, AND SENIOR DIRECTOR, DOMESTIC TAXES AND 
               TAX AFFAIRS, MICROSOFT CORPORATION

    Mr. Sample. Thank you, Mr. Chairman. Mr. Chairman and 
members of the subcommittee, my name is Bill Sample, Chairman 
of the R&D Credit Coalition and Senior Director of Domestic Tax 
and Tax Affairs at Microsoft. I am here today on behalf of the 
R&D Credit Coalition, which represents 87 professional and 
trade associations and more than 1,000 U.S. companies. We thank 
you for focusing on the tax treatment of R&D as part of your 
hearings on the Tax Code and the new economy and applaud the 
members of this committee for their continued commitment to a 
permanent R&D tax credit.
    As Chairman Houghton stated when announcing this hearing, 
the new economy is based on high-tech equipment, intensive 
research and development and a skilled workforce. The R&D tax 
credit, according to many Government and private-sector 
experts, as listed in my written testimony, is a proven, 
effective means of encouraging increased R&D activity in the 
United States, which in turn will help provide technology 
improvements to benefit the economy.
    I have spent the last 10 years working in the software 
industry and strongly believe in the economic and social 
benefits that result from high-risk investments in technology 
research. The last 10 years have also been very good for the 
U.S. economy and the products of technology research have 
helped create the budget surplus that is currently paying down 
the national debt. Technology-driven increases in productivity 
have also created more jobs for U.S. workers. Business Week 
recently reported on a NABE survey of economists that lowered 
the estimated maximum sustainable unemployment rate that would 
not fuel inflation from six percent down to four-and-a-half \1/
2\ percent. That 1.5 percent represents a significant increase 
in available jobs. The R&D credit encourages companies to hire 
more high-skilled, high-paid workers to fill those jobs.
    I would like to underscore the ripple effects of the 
economic success created by technology research on a more 
individual level. Whether it is the $18 million donated by 
Microsoft employees to the United Way in 1999, the software and 
hardware donated to schools and non-profits by our employees 
and our business partners, the educational software my two 
children use at home and at school or the e-mail and Internet 
technology that enables my wife to be den mother for my six-
year-old son's Tiger Cub Troop, the economic and social 
benefits of technology are helping many people improve their 
lives. These stories are repeated over and over again in the 
1,000 companies that make up the R&D Credit Coalition.
    This committee plays a critical role in overseeing that the 
U.S. Treasury and Internal Revenue Service properly administers 
the law consistent with congressional intent. As the person 
responsible for much of Microsoft's tax compliance, I can tell 
you that regulations and other administrative guidance often 
have more impact on our tax liability than the statutory 
language.
    In recent years, the U.S. Treasury and IRS have 
administered the R&D credit rules in such a way as to attempt 
to significantly reduce the scope of research activities 
eligible for the R&D credit. Despite clear guidance provided by 
Congress and the committee report language accompanying the 
1998 and 1999 extensions of the R&D credit and separate letters 
from committee members to Treasury, the IRS continues to apply 
the discovery test, common-knowledge test and process-of-
experimentation requirements of its proposed regulations 
defining eligible research pursuant to IRC Section 41(d) in its 
examination of taxpayers.
    Recently, a court admonished the IRS for taking positions 
that were clearly unsupported by the law. In Tax and Accounting 
Software Corporation versus the United States, the court 
rejected the IRS-proposed discovery and common-knowledge tests. 
The court held the IRS's, and I quote, ``Construction of the 
statutory language would be a strained and improper reading 
without any support in the legislative history to back it up, 
and further the IRS is completely missing the fact that 
Congress intended to encourage commercial research through the 
enactment of the R&D credit.''
    With respect to the process of experimentation requirements 
in the proposed regulations, the Tax Court found that, and I 
quote, ``The highly-structured definition of research which is 
proffered by the IRS in its regulations makes it virtually 
impossible for commercial research to qualify through the 
Section 41 credit, which was clearly not the intention of 
Congress.
    In conclusion, we should seize on the opportunity we have 
to take at least one critical positive step towards a 21st-
century Tax Code. Make the R&D credit permanent. Thank you and 
I am happy to take questions.
    [The prepared statement follows:]

Statement of Bill Sample, Chairman, R&D Credit Coalition, Redmond, 
Washington, and Senior Director, Domestic Taxes and Tax Affairs, 
Microsoft Corporation

    Mr. Chairman and members of the subcommittee, my name is 
Bill Sample, Chairman of the R&D Credit Coalition and Senior 
Director of Domestic Taxes & Tax Affairs at Microsoft. I am 
here today on behalf of The R&D Credit Coalition, which 
represents 87 professional and trade associations and more than 
1,000 U.S. companies. We thank you for focusing on the tax 
treatment of research and development as part of your hearings 
on the tax code and the new economy and applaud the members of 
this subcommittee and the full Ways and Means Committee for 
their continued commitment to a permanent R&D tax credit. Last 
year as part of the Tax and Trade Extension Act of 1999, this 
important tax credit was extended for five years, through June 
30, 2004, and a modest increase in the Alternative Incremental 
Research Credit was adopted. We look forward to working with 
you to finish the job and make the R&D credit permanent.
    This testimony will focus on: (1) the importance of making 
the R&D credit permanent; and (2) the need to address growing 
controversies in the administration of the R&D credit caused by 
positions taken by the Department of the Treasury and the IRS 
in examination, litigation, and the proposed R&D regulations.
    As the Committee members consider how well the tax code is 
``keeping pace'' with the new economy we urge you to encourage 
tax policies that will fuel the U.S. economy, keeping American 
companies and their workers prosperous and competitive in the 
changing global marketplace. Without a growing economy, 
Americans' standard of living, and our ability to support the 
needs of our aging population, will be in jeopardy. Faced with 
a static or decreasing workforce as U.S. demographics shift, 
U.S. lawmakers must focus on encouraging technology development 
to increase productivity, enabling a smaller workforce to 
support a growing population of retirees.
    As Chairman Houghton stated when announcing this hearing, 
``the 'new economy' is based on high-tech equipment, intensive 
research and development, and a skilled workforce.'' We could 
not agree more. Increased technology development will help to 
ensure sustained economic growth and the prosperous environment 
needed to continue to improve our standard of living for 
current and future generations of Americans. U.S. tax law 
should promote technology development in the U.S., and the most 
effective way to do that is through a permanent R&D tax credit.
    The R&D tax credit, according to many government and 
private sector experts, is a proven, effective means of 
encouraging increased research and development activity in the 
United States, which in turn will help provide the technology 
improvements to benefit the economy.
    In 1998, Coopers & Lybrand (now PricewaterhouseCoopers), an 
accounting firm, completed a study, Economic Benefits of the 
R&D Tax Credit, (January, 1998) that dramatically illustrates 
the significant economic benefits provided by the credit. 
According to the study, making the R&D credit permanent would 
stimulate substantial amounts of additional R&D in the U.S., 
increase national productivity and economic growth almost 
immediately, and provide U.S. workers with higher wages and 
after-tax income.
    There is a significant body of other evidence produced by 
the General Accounting Office, Bureau of Labor Statistics, 
National Bureau of Economic Research, and others, that likewise 
conclude that this credit represents a very sound investment in 
U.S. economic growth. As we enter the 21 st century with a 
projected budget surplus and continued economic promise, now is 
the time to make a long-term commitment to U.S. research and 
development and to make the R&D credit permanent.

                           I. The R&D Credit

A. Background

    As an incentive for companies to increase their U.S. R&D 
activities, Congress first enacted the R&D credit in 1981. The 
credit as originally passed was scheduled to expire at the end 
of 1985. Recognizing the importance and effectiveness of the 
provisions, Congress decided to extend it and continued to 
extend it on at least nine subsequent occasions. In addition, 
the credit's focus has been sharpened by limiting both 
qualifying activities and eligible expenditures. With each 
extension, the Congress indicated its strong bipartisan support 
for the R&D credit.
    In 1986, the credit lapsed, but was retroactively extended 
and the rate cut from 25 percent to 20 percent. In 1988, the 
credit was extended for one year, but its effectiveness was 
reduced by decreasing the deduction for R&D expenditures by 50% 
of the credit. In 1989, Congress extended the credit for 
another year, again reduced the effectiveness of the credit by 
decreasing the deduction for R&D expenditures by a full 100% of 
the credit, and made changes that were intended to increase the 
incentive effect for established as well as start-up companies. 
In the 1990 Budget Reconciliation Act, the credit was extended 
again for 15 months through the end of 1991. The Tax Extension 
Act of 1991 extended the credit again, through June 30, 1992. 
In OBRA 1993, the credit was retroactively extended through 
June 30, 1995.
    In 1996, as part of the Small Business Job Protection Act 
of 1996, the credit was extended for eleven months, through May 
31, 1997, but was not extended to provide continuity over the 
period July 1, 1995 to June 30, 1996. This one-year period, 
July 1, 1995 to June 30, 1996, was the first gap in the 
credit's availability since its enactment in 1981.
    In 1996, the elective Alternative Incremental Research 
Credit (``AIRC'') was added to the credit, increasing its 
flexibility and making the credit available to R&D intensive 
industries that could not qualify for the credit under the 
regular criteria. The AIRC adds flexibility to the credit to 
address changes in business models and R&D spending patterns 
that are a normal part of a company's life cycle.
    The Congress next approved a thirteen-month extension of 
the R&D credit that was enacted into law as part of the 
Taxpayer Relief Act of 1997. The credit was made available for 
expenditures incurred from June 1, 1997 through June 30, 1998, 
with no gap between this and the previous extension. In the Tax 
and Trade Extension Act of 1998, the Congress approved a one-
year extension of the credit, until June 30, 1999. In 1999, the 
credit was extended until June 30, 2004, and a modest increase 
in the AIRC rates was adopted that will bring the AIRC's 
incentive effect more into line with the incentive provided by 
the regular credit to other research-intensive companies.
    According to the Tax Reform Act of 1986, the R&D credit was 
originally limited to a five-year term in order ``to enable the 
Congress to evaluate the operation of the credit.'' While it is 
understandable that the Congress in 1981 would want to adopt 
this new credit on a trial basis, the credit has long since 
proven over the 19 years of its existence to be an excellent 
investment of government resources to provide an effective 
incentive for companies to increase their U.S.-based R&D. 
Recently released corporate data show significant increases in 
total qualified research eligible for the credit. The credit is 
working, and we should underscore its effectiveness by making 
it permanent.
    The historical pattern of temporarily extending the credit, 
combined with the first gap in the credit's availability, 
reduces the incentive effect of the credit. The U.S. research 
community needs a stable, consistent R&D credit in order to 
maximize its incentive value and its contribution to the 
nation's economic growth and sustain the basis for ongoing 
technology competitiveness in the global arena. While a five 
year extension of the credit is helpful, Congress should make 
the R&D credit permanent.

B. The Importance of an R&D Credit

1. Productivity Growth

    It is well recognized that ``[m]uch of the growth in 
national productivity ultimately derives from research and 
development conducted in private industry.'' See, Office of 
Technology Assessment (1995). Sixty-six to eighty percent of 
productivity growth since the Great Depression is attributable 
to such innovation. In an industrialized society R&D is the 
primary force driving technological innovation. Moreover, since 
companies cannot capture fully the rewards of their innovations 
(because they cannot control the indirect benefits of their 
technology on the economy), the rate of return to society from 
innovation is twice that which accrues to the individual 
company.
    Economists and technicians who have studied the issue agree 
that the government should intervene to increase R&D 
investment. In a study conducted by the Tax Policy Economics 
Group of Coopers & Lybrand (now PricewaterhouseCoopers), it was 
found that ``. . .absent the R&D credit, the marketplace, which 
normally dictates the correct allocation of resources among 
different economic activities, would fail to capture the 
extensive spillover benefits of R&D spending that raise 
productivity, lower prices, and improve international trade for 
all sectors of the economy.'' Stimulating private sector R&D to 
drive national productivity growth is particularly critical in 
light of the decline in government funded R&D over the years.

2. Global Competitiveness

    Private sector U.S.--based R&D is critical to the 
technological innovation and productivity advances that will 
maintain U.S. leadership in the world marketplace. Since 1981, 
when the credit was first adopted, there have been dramatic 
gains from R&D spending. Unfortunately, our nation's private 
sector investment in R&D (as a percentage of GDP) lags far 
below many of our major foreign competitors. For example, U.S. 
firms spend (as a percentage of GDP) only one-third as much as 
their German counterparts on R&D, and only about two-thirds as 
much as Japanese firms. This trend must not be allowed to 
continue if our nation is to remain competitive in the world 
marketplace.
    Foreign governments are competing aggressively for U.S. 
research investments by offering substantial tax and other 
financial incentives. Even without these tax incentives, the 
cost of performing R&D in many foreign jurisdictions is lower 
than the cost to perform equivalent R&D in the U.S. According 
to an OECD survey, the U.S. R&D tax credit as a percentage of 
industry-funded R&D was third lowest among nine countries 
analyzed. In order for U.S. businesses to remain competitive in 
this global environment, the R&D credit must remain in place on 
a permanent basis.

3. Reduced Cost of Capital

    The R&D credit reduces the cost of capital for businesses 
that increase their R&D spending. This results in more capital 
being available for innovative ventures that would otherwise 
not be undertaken because of risks involved with the project. 
When the cost of R&D is reduced, the private sector is likely 
to perform more of it. In most situations, the greater the 
scope of R&D activities, or risk, the greater the potential for 
return to investors, employees and society at large. By 
lowering the economic risk to companies seeking to initiate new 
research, the R&D credit will potentially lead to enhanced 
productivity and overall economic growth.

4. Cost Effective Tool to Encourage Economic Growth

    A number of economic studies \1\ of the credit have found 
that a one-dollar reduction in the after-tax price of R&D 
stimulates approximately one dollar of additional private R&D 
spending in the short-run, and about two dollars of additional 
R&D in the long run. The Coopers & Lybrand study estimated that 
a permanent extension of the R&D credit would create nearly $58 
billion of economic growth over the 1998-2010 period, including 
$33 billion of additional domestic consumption and $12 billion 
of additional business investment. These benefits stem from 
substantial productivity increases that could add more than $13 
billion per year of increased productive capacity to the U.S. 
economy. Accordingly, studies confirm that one of the most cost 
effective tools of encouraging economic growth would be the 
enactment of a permanent R&D credit.
---------------------------------------------------------------------------
    \1\ These include the Coopers & Lybrand 1998 study, the KPMG Peat 
Marwick 1994 study, and the article by B. Hall entitled: ``R&D Tax 
Policy in the 1980s: Success or Failure?'' Tax Policy and the Economy 
(1993).

---------------------------------------------------------------------------
5. Job Creation

    Dollars spent on R&D are primarily spent on salaries for 
engineers, researchers and technicians. When taken to market as 
new products, incentives that support R&D translate to salaries 
for employees in manufacturing, administration and sales. Of 
exceptional importance to many members of the R&D Credit 
Coalition, R&D success also means salaries to the people in our 
distribution channels who bring our products to our customers 
as well as service providers and developers of complementary 
products. And, our customers ultimately drive the entire 
process by the value they place on the benefits from advances 
in technology (benefits that often translate into improving 
their ability to compete and lower prices for consumers). By 
making other industries more competitive, research within one 
industry contributes to preserving and creating jobs across the 
entire U.S. economy. The R&D credit and investment in R&D is 
ultimately an investment in people, their education, their 
jobs, their economic security, and their standard of living.

The R&D credit is available to all qualifying taxpayers

    Any taxpayer that increases their U.S. R&D spending and 
meets the technical requirements provided in the law can 
qualify for the credit. By utilizing the R&D credit, businesses 
of all sizes, and in all industries, can best determine what 
types of products and technology to invest in so that they can 
ensure their competitiveness in the world marketplace. As such, 
the R&D credit is a meaningful, market-driven tool to encourage 
private sector investment in research and development 
expenditures in the U.S. that should be made permanent.

              II. The R&D Credit should be made permanent

    In order to achieve the maximum incentive effect, the R&D 
credit should be made permanent. As recently recognized by the 
Joint Committee on Taxation, ``[i]f a taxpayer considers an 
incremental research project, the lack of certainty regarding 
the availability of future credits increases the financial risk 
of the expenditure.'' See, Description of Revenue Provisions in 
the President's Fiscal Year 2000 Budget Proposal (JCS-1-99). 
Research projects cannot be turned off and on like a light 
switch and generally represent multi-year commitments; if 
corporate managers are going to take the benefits of the R&D 
credit into account in planning future research projects, they 
need to know that the credit will be available to their 
companies for the years in which the research is to be 
performed. Research projects have long horizons and extended 
gestation periods. Furthermore, firms generally face longer 
lags in adjusting their R&D investments compared, for example, 
to adjusting their investments in physical capital.
    In the normal course of business operations, R&D 
investments take time and planning. Businesses must search for, 
hire, and train scientists, engineers and support staff, and in 
many cases invest in new physical plants and equipment. There 
is little doubt that some of the incentive effect of the credit 
has been lost over the past nineteen years as a result of the 
constant uncertainty over the continued availability of the 
credit. This must be corrected so that the full potential of 
its incentive effect can be felt across all sectors of our 
economy.
    In order to provide for the maximum potential for increased 
R&D activity, and for the government to maximize its return on 
tax dollars invested in the credit, the practice of 
periodically extending the credit for short periods, and then 
allowing it to lapse, must be eliminated, and the R&D credit 
must be made permanent.

      III. Problems with the proposed R&D regulations and growing 
         controversies in the Administration of the R&D Credit

    The economic benefits of permanently extending the R&D 
credit will be significantly reduced, however, if the credit is 
administered by the government in a manner contrary to the 
intent of Congress. Improper implementation and administration 
of the law could reduce the credit eligibility of legitimate 
research activities. Despite the broad support for this tax 
incentive, and additional guidance by the Congress on the 
proper administration of the credit (e.g., legislative history 
and letters), there remain significant problems with the manner 
in which the IRS administers the law and interprets the 
application of R&D credit eligibility rules to corporate 
research activities. Many of these problems are the direct 
result of positions taken by the Administration in regulations 
interpreting the R&D tax credit under Internal Revenue Code 
section 41 (``the proposed R&D regulations'') \2\ and in tax 
examinations and litigation.
---------------------------------------------------------------------------
    \2\ Prop. Regs. Sections 1.41-1 to 1.41-8, Vol. 63 Fed. Reg. No. 
231, 63 FR 66503.
---------------------------------------------------------------------------
    The growing controversy created by the proposed R&D 
regulations has been well known for some time. These 
regulations attempt to significantly reduce the scope of 
``qualified research'' through the use of a discovery test that 
turns in part, on a proposed ``common knowledge'' test. Over 
four dozen witnesses representing a broad cross-section of 
businesses and industry raised significant concerns about these 
proposed regulations in oral and written testimony before the 
Department of the Treasury and IRS. The public hearing on the 
proposed regulations was attended by over 100 practitioners and 
corporate taxpayers. Nearly every witness who testified argued 
for significant changes to the proposed rules, including the 
elimination of the proposed ``common knowledge'' test. Many 
felt that left unchanged, the proposed ``common knowledge'' 
test could cause increased administrative burden and 
complexity, result in questionable tax increases by eliminating 
the credit eligibility of many legitimate research projects, 
and violate Congressional intent for the application of the R&D 
credit.
    As evidenced by the volume and scope of these public 
comments, the proposed R&D regulations are extremely 
controversial and have caused great uncertainty for taxpayers 
and the IRS in the examination process. In addition, recent IRS 
National Office guidance in the form of a Coordinated Issue 
Paper (``CIP'') relies on concepts from the proposed R&D 
regulations to support its analysis and holdings. See, 
Coordinated Issue All Industries Research Tax Credit--Qualified 
Research (Release Date: August 30, 1999). The CIP incorporates 
the ``common knowledge'' test proposed in the regulations 
almost verbatim and cites it as authority. Even though the 
regulations are proposed and recognized as controversial, the 
IRS is currently applying the principles of these proposed 
regulations to deny credit eligibility.
    These problems have also been recognized by the Chairman 
and other Members of this Committee. As recently as last month, 
Chairman Bill Archer and Representatives Nancy Johnson and 
Robert Matsui wrote to Treasury Secretary Summers expressing 
their concern regarding the administrability of the R&D credit 
by both the government and taxpayers. In their letter of August 
17, 2000, these Members expressed concern about allegations 
that during the comment period on the proposed R&D regulations, 
``IRS agents are misapplying the proposed regulations and 
misinterpreting the clear statutory intent of the definition of 
qualified research.'' They went on to emphasize that any final 
regulations should be consistent with Congressional intent.
    In a separate letter dated August 21, 2000, Representatives 
Johnson and Matsui wrote to Secretary Summers reiterating their 
concerns by stating the following:
    ``This reliance by the IRS on proposed rules, which are 
subject to further administrative actions, evidences a 
disregard for the administrative rulemaking process and 
inappropriate tax administration of the statutory provisions of 
section 41. These actions also reflect the fact that there may 
not be a full appreciation within the IRS, in both the National 
and field offices, of the level of concern surrounding the 
proposed rules from both a policy and practical perspective.
    The problems and controversy surrounding the use of a 
discovery test that incorporates a ``common knowledge'' test is 
the result of positions taken by the Department of the Treasury 
and the IRS in examination, litigation, and the proposed R&D 
regulations. These problems and controversy are unnecessary, 
since the test contained in the proposed R&D regulations was 
never contemplated nor endorsed by Congress as part of the R&D 
tax credit.
    In fact, as part of the conference report to the Ticket to 
Work and Work Incentives Improvement Act of 1999 (Pub. L. 106-
170), Congress urged you ``to consider carefully the comments 
[you] have received regarding the proposed regulations relating 
to . . . the definition of qualified research under section 
41(d), particularly regarding the 'common knowledge' test.'' 
\3\
---------------------------------------------------------------------------
    \3\ Ticket to Work and Work Incentives Improvement Act of 1999, 
Conf. Rpt. 106-478, page 132 (Nov. 17, 1999).
---------------------------------------------------------------------------
    At the time, Congress also reaffirmed ``that qualified 
research is research undertaken for the purpose of discovering 
new information which is technological in nature;'' and that 
``new information is information that is new to the taxpayer, 
is not freely available to the general public, and otherwise 
satisfies the requirements of section 41.'' \4\
---------------------------------------------------------------------------
    \4\ Id.
---------------------------------------------------------------------------
    We understand that public comments on the proposed R&D 
regulations are now being carefully reviewed by your staff and 
we are encouraged by such actions. At the same time, we remain 
concerned that during this comment period, IRS agents are 
misapplying the regulations and/or misinterpreting the clear 
statutory intent of the definition of ``qualified research.''
    Given the unique nature of these proposed R&D regulations, 
the genuine controversy reflected in public comments on the 
issue of the discovery and ``common knowledge'' tests, and the 
problems they are causing in the tax examination and audit 
process, we urge that at the very least the final R&D 
regulations do not contain a ``common knowledge'' test or any 
other rules inconsistent with the Congressional intent as 
espoused most recently in the legislative history to the Ticket 
to Work and Work Incentives Improvement Act of 1999. We also 
urge the Department of the Treasury and the IRS to allow a 
further public comment period on changes they may be 
considering on any controversial aspect of the regulations 
before the regulations are finalized.
    Left unchanged and outstanding, any rules that incorporate 
the ``common knowledge'' test contained in the proposed 
regulations will cause more confusion, controversy and 
administrative burdens, without furthering the underlying 
legislative intent of the R&D tax credit. We believe such 
results will harm rather than help the current Administration's 
efforts to encourage R&D investments and to support the R&D tax 
credit.'' See, Letter From Representatives Johnson and Matsui 
to Secretary Summers (dated August 21, 2000)
    The R&D Coalition strongly endorses these statements and 
encourages this committee to pursue any actions available to 
work with the Department of the Treasury and the IRS to resolve 
these problems with the proposed R&D regulations.
    The proposed R&D regulations also go beyond legislative 
intent in their proposed definition of ``process of 
experimentation,'' and implication of an additional record 
keeping requirement in order to qualify for the credit. The 
proposed regulations take an inappropriate academic view in 
defining the phrase ``process of experimentation'' and add 
requirements not present in the underlying statute. In 
addition, the proposed regulations appear to add a new 
substantiation requirement (in the form of a rule that seems to 
require contemporaneous recording of the results of 
experiments) into the basic definition of qualified research. 
Both positions are inconsistent with and beyond the legislative 
history underlying the R&D credit.
    Recently, a court admonished the use by the IRS of 
positions that were clearly unsupported by the law. In Tax and 
Accounting Software Corp. v. U.S., N.D. Okla. (July 31, 2000), 
the court rejected the IRS's proposed ``discovery'' test and 
the opinions of the courts in Norwest Corporation and 
Subsidiaries v. Commissioner of Internal Revenue, 110 T.C. 454 
(1998) and United Stationers, Inc. v. United States, 982 F. 
Supp. 1279 (N.D. Ill. 1997), affirmed 163 F.3d 440 (7th Cir. 
1998) that relied on a ``discovery test'' to qualify for the 
R&D credit. The court held that ``that construction of the 
statutory language would be a strained and improper reading 
without any support in the legislative history to back it up.'' 
Tax and Accounting Software Corp. v. U.S., Order (p. 9).
    The court went on to find that ``there is no support'' in 
the statute or legislative history for the position contained 
in the proposed R&D regulations that requires ``obtaining 
knowledge that exceeds, expands, or refines the common 
knowledge of skilled professionals in the particular field of 
technology or science.'' It further said that ``the IRS is 
completely missing the fact that Congress intended to encourage 
commercial research'' through the enactment of the R&D credit. 
Id. at p.14.
    Importantly, the court concluded by stating that ``[T]he 
highly structured definition of research which is proffered by 
the IRS in its regulations makes it virtually impossible for 
commercial research to qualify for the section 41 credit, which 
was clearly not the intention of Congress. Id. at p. 14 
(emphasis added).
    Despite these obvious controversies with the regulations 
and the unsupported positions taken by the IRS in the proposed 
R&D regulations, in examination and in litigation, there is no 
indication that changes are being instituted to correct these 
glaring problems. We therefore, encourage you and this 
committee to take all actions necessary to ensure that the R&D 
credit incentive, which is so valuable to our national economy, 
is not undermined by the regulators that implement this law.

                             IV. Conclusion

    There is a unique opportunity in this time of economic 
prosperity to take a thoughtful look at whether our tax laws 
are a help or hindrance to sustained growth and the 
competitiveness of U.S. businesses. We should seize on the 
opportunity we have to take at least one critical positive step 
toward a 21st century tax code--make the R&D Credit permanent.
    Private sector R&D in the U.S. stimulates investment in 
innovative products and processes that greatly contribute to 
overall economic growth, increased productivity, new and better 
U.S. jobs, and higher standards of living in the United States. 
Moreover, by creating an environment favorable to private 
sector R&D investment in the U.S., jobs will remain in the 
United States. Investment in R&D is an investment in people. A 
permanent R&D credit is essential for the United States economy 
in order for its industries to compete globally, as 
international competitors have chosen to offer direct financial 
subsidies and reduced capital cost incentives to ``key'' 
industries.
    Finally, in order to ensure that these objectives are met, 
the R&D credit laws must be administered and regulated in a 
manner consistent with Congressional intent and not in a manner 
that undermines the national goals of this well-supported 
public policy.
    Thank you, and I am happy to take any questions.
      

                                


    Chairman Houghton. Thanks very much. Mr. Capps.

  STATEMENT OF R. RANDALL CAPPS, CORPORATE TAX DIRECTOR, AND 
   GENERAL TAX COUNSEL, ELECTRONIC DATA SYSTEMS CORPORATION, 
                          PLANO, TEXAS

    Mr. Capps. Good morning, Mr. Chairman and members of the 
committee. My name is Randy Capps and I am Tax Director for 
Electronic Data Systems Corporation. I would like to thank you 
for this opportunity to speak with you about the research and 
experimentation tax credit. EDS has been a leader in the 
information technology services industry for more than 35 
years. Our leadership depends on continuous reinvention of our 
products and our services. Our 120,000 employees deliver 
management consulting and electronic business solutions to more 
than 9,000 business and Government clients in over 50 
countries.
    Each year, we spend more than $1.7 billion on a wide range 
of research and development. EDS researchers have, for example, 
developed programs that help health insurers control costs. We 
developed a manufacturing system, using a computer language 
tailored for the semiconductor industry, that guided silicon 
wafers from one production location to another. We are focusing 
today on development of programs to guard against cyber-
terrorism in the digital economy.
    My industry was born out of high-cost, high-risk research. 
It is driven by the creativity of thousands of innovative 
corporations. The R&D yields products and services that are 
improving lives and generating productivity increases 
throughout the economy.
    Since the R&D credit was enacted in 1981, it has been 
extended 10 times. With each extension, Congress indicated 
strong bipartisan support. Last year, Congress extended the 
credit for five years. Earlier this year, the Senate voted 98-
to-one in favor of an amendment to the estate tax bill that 
would have made the credit permanent. All amendments were 
stripped from the final bill, but the bipartisan support was a 
strong indicator of the importance of the credit to members 
from all parts of the country.
    So, why is the credit so important? First, it offsets the 
tendency for underinvestment in R&D. The single-biggest factor 
driving productivity growth is innovation. However, companies 
cannot profit from the indirect benefits of the technology to 
the economy. As a result, the rate of return of R&D to society 
is twice that which accrues to an individual company.
    The second reason why it is so important: The credit helps 
U.S. business remain competitive in world markets. Foreign 
governments are competing aggressively for research investments 
by offering substantial tax and other financial incentives. 
Companies that do research in the United States are at a 
disadvantage when competing with foreign-based multinationals 
that have lower research costs.
    Third, R&D spending is very responsive to the credit. 
Economic studies of the credit have found a one-dollar 
reduction in the after-tax cost of R&D stimulates approximately 
one dollar of additional private R&D spending in the short run 
and about two dollars of additional R&D spending in the long 
run.
    Most important, research and development is about jobs and 
it is about people. Investment in R&D is ultimately an 
investment in people, their education, their jobs, their 
economic security and their standard of living.
    Dollars spent on R&D are primarily spent on salaries for 
engineers, researchers and technicians. At EDS, more than 90 
percent of the expenses qualifying for the R&D credit go to 
salaries for U.S. employees who are directly involved in 
research. When R&D results in new products and services, the 
incentives that support R&D translate into salaries of 
employees in production, administration and sales. By making 
other industries more competitive, research in one industry 
contributes to the creation of jobs across the entire economy.
    Research projects cannot be turned on and off like a light 
switch. The most important thing that you as leaders in the tax 
legislative process can do to promote sustained investment in 
long-term research is to make the credit permanent. House 
Speaker Dennis Hastert, Minority Leader Dick Gephardt, Senate 
Majority Leader Trent Lott, Minority Leader Tom Daschle, Vice 
President Al Gore and Texas Governor George Bush have all 
endorsed the permanent R&D credit.
    This week's issue of Time magazine includes a story 
entitled ``Hooray for R&D: It is Time to Make a Popular and 
Effective Tax Credit Permanent.'' That is exactly what I am 
asking you to do. Thank you and I would be happy to answer any 
questions you may have.
    [The prepared statement follows:]

Statement of R. Randall Capps, Corporate Tax Director, and General Tax 
Counsel, Electronic Data Systems Corporation, Plano, Texas

    Good morning. Mr. Chairman and members of the committee. My 
name is Randy Capps, and I am Corporate Tax Director for 
Electronic Data Systems. I would like to thank you for the 
opportunity to speak with you about the research and 
experimentation tax credit and to thank you and all the members 
of the subcommittee who have supported the credit over the 
years.
    EDS has been a leader in the global information technology 
services industry for more than 35 years. Our 120,000 employees 
deliver management consulting and electronic business solutions 
to more than 9,000 business and government clients in 
approximately 50 countries. EDS reported revenues of $18.5 
billion in 1999. EDS spends more than $1.7 billion on research 
and development every year.
    For example, EDS researchers have developed programs that 
help health insurers to control costs and a manufacturing 
system, using a computer language tailored for the 
semiconductor industry, to guide silicon wafers from one 
production station to another. Today, a major focus is to 
develop programs to guard against cyber terrorism in the 
digital economy.
    The information technology services industry was born out 
of basic research and is driven by the applied research of 
hundreds of innovative corporations. This corporate R&D 
produces a growing range of products and services that are 
generating productivity increases throughout the economy. The 
technological revolution that is occurring in my industry is 
replicated in many others. These industries are reinventing 
themselves and in the process are creating a broad range of 
high-paid, high-skilled jobs in the United States.
    R&D is the primary source of technological innovation. 
According to the U.S. Office of Technology Policy, 
technological innovation has accounted for up to half of U.S. 
economic growth during the past five decades.

                   I. R&D Credit Legislative History

    The R&D credit was enacted in 1981 to provide an incentive 
for companies to increase their U.S. R&D activities. As 
originally passed, the R&D credit was to expire at the end of 
1985. Recognizing the importance and effectiveness of the 
provisions, Congress decided to extend it. In fact, since 1981 
the credit has been extended ten times. In addition, the 
credit's focus has been sharpened by limiting qualifying 
activities and eligible expenditures. With each extension, 
Congress indicated its strong bipartisan support for the R&D 
credit. Most recently, Congress approved a five-year extension 
of the credit, until June 30, 2004.
    This year, the Senate voted 98 to 1 in favor of an 
amendment that would have added a permanent R&D tax credit to 
the estate tax bill. For reasons unrelated to the credit, all 
amendments were stripped from the bill. However, I believe this 
vote was a strong indication that members of Congress recognize 
the contribution of the credit to economic growth.
    In 1996, the elective Alternative Incremental Research 
Credit (``AIRC'') was added to the credit, increasing its 
flexibility and making the credit available to R&D intensive 
industries which could not qualify for the credit under the 
regular criteria. The AIRC adds flexibility to the credit to 
address changes in business models and R&D spending patterns 
which are a normal part of a company's life cycle.
    According to the conference report of the Tax Reform Act of 
1986, the R&D credit was originally limited to a five-year term 
in order ``to enable the Congress to evaluate the operation of 
the credit.'' It is understandable that Congress in 1981 would 
want to adopt this new credit on a trial basis. The credit has 
long since proven to be an excellent, highly leveraged 
investment of government resources to provide an effective 
incentive for companies to increase their U.S.--based R&D.
    The historical pattern of temporarily extending the credit 
reduces the incentive effect of the credit. The U.S. research 
community needs a stable, consistent R&D credit in order to 
maximize its incentive value and its contribution to the 
nation's economic growth.

                   II. Why do we Need an R&D Credit?

A. The credit offsets the tendency for under investment in R&D

    The single biggest factor driving productivity growth is 
innovation. As stated by the Office of Technology Assessment in 
1995: ``Much of the growth in national productivity ultimately 
derives from research and development conducted in private 
industry.'' Sixty-six to 80 percent of productivity growth 
since the Great Depression is attributable to innovation. In an 
industrialized society, R&D is the primary means by which 
technological innovation is generated.
    Companies cannot capture fully the rewards of their 
innovations because they cannot control the indirect benefits 
of their technology on the economy. As a result, the rate of 
return to society from innovation is twice that which accrues 
to the individual company. This situation is aggravated by the 
high risk associated with R&D expenditures. As many as 80 
percent of such projects are believed to be economic failures.
    Therefore, economists and technicians who have studied the 
issue are nearly unanimous that the government should intervene 
to increase R&D investment. A recent study, conducted by the 
Tax Policy Economics Group of Coopers & Lybrand, now part of 
PriceWaterhouseCoopers, concluded that ``. . .absent the R&D 
credit, the marketplace, which normally dictates the correct 
allocation of resources among different economic activities, 
would fail to capture the extensive spillover benefits of R&D 
spending that raise productivity, lower prices, and improve 
international trade for all sectors of the economy.'' 
Stimulating private sector R&D is particularly critical in 
light of the decline in government funded R&D over the years. 
Direct government R&D funding has declined from 57 percent to 
36 percent of total R&D spending in the U.S. from 1970 to 1994. 
Over this same period, the private sector has become the 
dominant source of R&D funding, increasing from 40 percent to 
60 percent.

B. The credit helps U.S. business remain competitive in a world 
marketplace

    The R&D credit has played a significant role in placing 
American businesses ahead of their international competition in 
developing and marketing new products. It has assisted in the 
development of new and innovative products; providing 
technological advancement, more and better U.S. jobs, and 
increased domestic productivity and economic growth. This is 
increasingly true in our knowledge and information-driven world 
marketplace.
    Research and development must meet the pace of competition. 
In many instances, the life cycle of new products is 
continually shrinking. As a result, the pressure of getting new 
products to market is intense. Without robust R&D incentives 
encouraging these efforts, the ability to compete in world 
markets is diminished.
    Continued private sector R&D is critical to the 
technological innovation and productivity advances that will 
maintain U.S. leadership in the world marketplace. Since 1981, 
when the credit was first adopted, there have been dramatic 
gains in R&D spending. Unfortunately, our nation's private 
sector investment in R&D (as a percentage of GDP) lags far 
below many of our major foreign competitors. For example, U.S. 
firms spend (as a percentage of GDP) only one-third as much as 
their German counterparts on R&D, and only about two-thirds as 
much as Japanese firms. This trend must not be allowed to 
continue if our nation is to remain competitive in the world 
marketplace.
    Moreover, we can no longer assume that American companies 
will automatically choose to site their R&D functions in the 
United States. Foreign governments are competing aggressively 
for U.S. research investments by offering substantial tax and 
other financial incentives. Even without these tax incentives, 
the cost of performing R&D in many foreign jurisdictions is 
lower than the cost to perform equivalent R&D in the U.S.
    An OECD survey of 16 member countries found that 13 offer 
R&D tax incentives. Of the 16 OECD nations surveyed, 12 provide 
an R&D tax credit or allow a deduction for more than 100 
percent of R&D expenses. Six OECD nations provide accelerated 
depreciation for R&D capital. According to the OECD survey, the 
U.S. R&D tax credit as a percentage of industry-funded R&D was 
third lowest among nine countries analyzed.
    In July of this year, the UK government revised its R&D tax 
rules to provide increased incentives for small and medium size 
companies. Stephen Beyers, UK secretary of state for trade and 
industry, said of the change: ``I want the UK to be the most 
attractive location for companies to conduct R&D.''
    Making the U.S. R&D tax credit permanent would markedly 
improve U.S. competitiveness in world markets. The 1998 Coopers 
& Lybrand study found that, with a permanent credit, annual 
exports of goods manufactured here would increase by more than 
$6 billion, and imports of good manufactured elsewhere would 
decrease by nearly $3 billion. Congress and the Administration 
must make a strong and permanent commitment to attracting and 
retaining R&D investment in the United States. The best way to 
do that is to permanently extend the R&D credit.

C. The credit provides a targeted incentive for additional R&D 
investment, increasing the amount of capital available for 
innovative and risky ventures

    The R&D credit reduces the cost of capital for businesses 
that increase their R&D spending, thus increasing capital 
available for risky research ventures.
    Products resulting from R&D must be evaluated for their 
financial viability. Market factors are providing increasing 
incentives for controlling the costs of business, including 
R&D. Based on the cost of R&D, the threshold for acceptable 
risk either rises or falls. When the cost of R&D is reduced, 
the private sector is likely to perform more of it. In most 
situations, the greater the scope of R&D activities, or risk, 
the greater the potential for return to investors, employees 
and society at large.
    The R&D credit is a vital tool to keep U.S. industry 
competitive because it frees-up capital to invest in leading 
edge technology and innovation. It makes available additional 
financial resources to companies seeking to accelerate research 
efforts. It lowers the economic risk to companies seeking to 
initiate new research, which will potentially lead to enhanced 
productivity and overall economic growth.

D. Private industrial R&D spending is very responsive to the 
R&D credit, making the credit a cost effective tool to 
encourage economic growth

    Economic studies of the credit, including the Coopers & 
Lybrand 1998 study, the KPMG Peat Marwick 1994 study, and the 
article by B. Hall entitled: ``R&D Tax Policy in the 1980s: 
Success or Failure?'' Tax Policy and the Economy (1993), have 
found that a one-dollar reduction in the after-tax price of R&D 
stimulates approximately one dollar of additional private R&D 
spending in the short-run, and about two dollars of additional 
R&D in the long run. The Coopers & Lybrand study predicts that 
a permanent R&D credit would lead U.S. companies to spend $41 
billion more (1998 dollars) on R&D for the period 1998-2010 
than they would in the absence of the credit. This increase in 
private U.S. R&D spending, the 1998 study found, would produce 
substantial and tangible benefits to the U.S. economy.
    Coopers & Lybrand estimated that this permanent extension 
would create nearly $58 billion of economic growth over the 
same 1998-2010 period, including $33 billion of additional 
domestic consumption and $12 billion of additional business 
investment. These benefits, the 1998 study found, stemmed from 
substantial productivity increases that could add more than $13 
billion per year of increased productive capacity to the U.S. 
economy. Enacting a permanent R&D credit would lead U.S. 
companies to perform significantly more R&D, substantially 
increase U.S. workers' productivity, and dramatically grow the 
domestic economy.

E. Research and Development is About Jobs and People

    Investment in R&D is ultimately an investment in people, 
their education, their jobs, their economic security, and their 
standard of living. Dollars spent on R&D are primarily spent on 
salaries for engineers, researchers and technicians.
    When R&D results in new products and services, the 
incentives that support R&D translate into salaries of 
employees in manufacturing, administration and sales. 
Successful R&D also means salaries to people in the 
distribution channels who bring new products to customers, 
service providers and developers of complementary products. 
Finally, customers benefit from advances in technology that 
improve their productivity and ability to compete. By making 
other industries more competitive, research within one industry 
contributes to preserving and creating jobs across the entire 
economy.
    At EDS more than 90 percent of expenses qualifying for the 
R&D credit go to salaries for employees directly involved in 
research. These are high-skill, high-wage jobs that employ U.S. 
workers. Investment in R&D, in people working to develop new 
ideas, is one of the most effective strategies for U.S. 
economic growth and competitive vitality. Indeed, the 1998 
Coopers & Lybrand study shows improved worker productivity 
throughout the economy with the resulting wage gains going to 
hi-tech and low-tech workers alike. U.S. workers' personal 
income over the 1998-2010 period, the 1998 study predicts, 
would increase by more than $61 billion if the credit were 
permanently extended.

F. The R&D credit is a market driven incentive

    The R&D credit is a meaningful, market-driven tool to 
encourage private sector investment in research and development 
expenditures. Any taxpayer that increases their R&D spending 
and meets the technical requirements provided in the law can 
qualify for the credit. Instead of relying on government-
directed and controlled R&D spending, businesses of all sizes, 
and in all industries, can determine what types of products and 
technology to invest in so that they can ensure their 
competitiveness in the world marketplace.

III. The R&D Credit should be made Permanent to have Maximum Incentive 
                                 Effect

    As the Joint Committee on Taxation pointed out in the Description 
of Revenue Provisions in the President's Fiscal Year 2000 Budget 
Proposal (JCS-1-99), ``If a taxpayer considers an incremental research 
project, the lack of certainty regarding the availability of future 
credits increases the financial risk of the expenditure.'' Research 
projects cannot be turned off and on like a light switch. If corporate 
managers are going to take the benefits of the R&D credit into account 
in planning future research projects, they need to know that the credit 
will be available to their companies for the years in which the 
research is to be performed. Research projects have long horizons and 
extended gestation periods. Furthermore, firms generally face longer 
lags in adjusting their R&D investments compared, for example, to 
adjusting their investments in physical capital.
    In order to increase their R&D efforts, businesses must search for, 
hire, and train scientists, engineers and support staff. They must 
often invest in new physical plants and equipment. There is little 
doubt that a portion of the incentive effect of the credit has been 
lost over the past 17 years as a result of the constant uncertainty 
over the continued availability of the credit.
    If the credit is to provide its maximum potential for increased R&D 
activity, the practice of periodically extending the credit for short 
periods and then allowing it to lapse, must be eliminated, and the 
credit must be made permanent. Only then will the full potential of its 
incentive effect be felt across all the sectors of our economy. No one 
has said this more forcefully than Federal Reserve Chairman Alan 
Greenspan who testified at last year's high technology summit. Chairman 
Greenspan was emphatic in his conclusion that, if there is a credit, it 
should be permanent.
    House Speaker Dennis Hastert, House Minority Leader Richard 
Gephard, Senate Majority Leader Trent Lott, Senate Minority Leader Tom 
Daschle, Vice President Al Gore, and Texas Governor George Bush have 
endorsed a permanent R&D credit.

                             IV. Conclusion

    Making the R&D credit permanent promotes the long-term 
economic interests of the United States. It will eliminate the 
uncertainty over the credit's future and enable businesses to 
make better long-term decisions regarding investments in 
research. Private sector R&D leads to innovative products and 
processes that contribute to economic growth, increased 
productivity, new and better U.S. jobs, and higher standards of 
living for all Americans. By creating an environment favorable 
to private sector R&D investment, a permanent credit will make 
it easier for U.S. companies to compete effectively in the 
global economy and help to ensure the growth of high-skill jobs 
in the United States.
    EDS strongly supports the permanent extension of the R&D 
credit. Last year's enactment of a five-year extension provided 
the business community with its first opportunity to consider 
the benefits of a long term extension when calculating the 
costs of long-term, high cost research projects. Unfortunately, 
the lack of permanence means that the uncertainty of making 
such calculations increases every year.
    The U.S. economy is experiencing remarkable economic 
growth. Much of this growth reflects R&D investments that were 
made years ago. The time has come to invest in the future. I 
urge you to include a permanent R&D credit in the first 
available vehicle.
      

                                


    Chairman Houghton. Thanks very much, Mr. Capps.
    Ms. Evans, we are going to have to break pretty soon, but 
please go ahead with your testimony and we will suspend and 
then we will come right back.

STATEMENT OF LINDA EVANS, PROGRAM DIRECTOR, TAXES AND FINANCE, 
                   GOVERNMENTAL PROGRAMS, IBM

    Ms. Evans. Mr. Chairman, members of the subcommittee, on 
behalf of IBM, I thank you for the opportunity to share our 
views on the R&D credit. My name is Linda Evans, Program 
Director, Finance and Tax Policy, with IBM Governmental 
Programs. As a key player in the information technology 
industry, or IT, IBM strives to lead in the creation, 
development and manufacturing of the industry's most advanced 
information technologies, which includes computer systems, 
software, networking systems, storage devices and 
microelectronics.
    We also have a worldwide network of services solution teams 
that translate these advanced technologies into value for 
private-and public-sector customers. Without question, the key 
to IBM's success is its record of innovation, which is made 
possible by R&D. The R&D credit and the alternative incremental 
research credit, or the AIRC, are useful tools to facilitate 
business research investment and I will speak more about that 
in a minute.
    I would like to first say a few words about the power of 
the IT industry and how it brings value to the economy and 
society. I think it fair to say that the IT industry has had a 
significant impact on the growth of the United States economy 
and, according to studies by the Department of Commerce, while 
IT growth accounts for a relatively small share of the 
economy's total output, about 8.3 percent in 2000, that growth 
has contributed nearly one-third of real U.S. economic growth 
between 1995 and 1999.
    Productivity is a measure of economic health and as you 
know Federal Reserve Board Chairman Alan Greenspan has said on 
more than one occasion that information technologies have had a 
positive effect on productivity growth. Further, according to 
the Department of Commerce, IT and electronic commerce, which 
are part and parcel of the new economy, will drive economic 
growth for years to come. Now, how is this phenomenal growth 
sustained?
    The relentless drive of IT, which fuels productivity and 
brings us societal benefits, relies heavily on R&D, which is 
the lifeblood of innovation. The IT industry must innovate to 
survive. What role does the credit play in all of this? With 
the R&D credit, the Government is supporting the view that R&D 
is essential for innovation and economic growth. Last year's 
five-year extension of the credit and the improvement of the 
AIRC provides some of the predictability that industry has 
sought over nine years of annual renewals.
    A permanent credit, of course, will provide even greater 
certainty for companies that are planning long-term research 
investments and we thank you for last year's extension. A 
testament to the value of R&D and innovation for IBM is the 
fact that for the seventh year in a row, the company has earned 
more U.S. patents than any other company in the world. In fact, 
in 1999, IBM earned 2,756 patents, which was 900 more than the 
next company. IBM continues to seek ways to make computer 
technology work faster and more effectively.
    This includes breakthrough chip-making processes to produce 
the next generation of computer chips, which are the brains of 
computers, and progress in storage density to make products for 
increasingly mobile workers in the new economy who will need 
the convenience, portability and greater computing power. The 
computing power, software developments and simulation 
capabilities of IBM's technology are bringing better 
understanding and faster solutions to the world's scientific, 
medical and environmental problems.
    For example, a big challenge for IBM is to simulate the 
folding of a complex protein, and for that IBM will build a 
supercomputer called Blue Gene, whose power will be needed to 
unlock the code of some 3 billion chemical structures.
    Chairman Houghton. Could I interrupt a minute? Listen, I am 
terribly sorry, but since I am the only one here and I have got 
to go and vote, could we suspend the proceedings and I will 
rush over and I will come right back and I will wait for the 
finish of your testimony. And then we can move to Ms. Hutter; 
okay?
    Ms. Evans. Certainly.
    Chairman Houghton. Thanks very much.
    [Recess.]
    Chairman Houghton. Well, again, thanks for bearing with us. 
Let's continue. Ms. Evans, right in mid-sentence?
    Ms. Evans. Thank you, Mr. Chairman. The computing power, 
software advancements and simulation capabilities of IBM's 
technology are bringing better understanding and faster 
solutions to the world's scientific, medical and environmental 
problems. For example, a big challenge for IBM is to simulate 
the folding of a complex protein, and for that the company will 
build a supercomputer called Blue Gene, whose power will be 
needed to unlock the code of some three billion chemical 
structures.
    And there is Deep Thunder, IBM's weather-modeling 
visualization system that will more accurately predict local 
weather patterns and violent weather phenomena such as 
thunderstorms and wind shear. IBM uses its IT to leverage the 
power of the Internet to help businesses of all sizes expand 
their reach in electronic commerce. In the area of education, 
improving K-12 and lifelong learning are important national 
concerns and IBM's strong historical commitment to improving 
schools leads us to develop technologies and expertise for 
teaching methods, including Internet-based methods that will 
facilitate and improve the way kids learn and the way teachers 
teach.
    In conclusion, today you will have heard from my colleagues 
and myself about some of the ways our companies innovate. You 
will have learned that innovation is a central focus of the IT 
industry and that research and development fuels innovation. 
The research credit remains an important tool in creating a 
positive environment for this to continue.
    Thank you very much.
    [The prepared statement follows:]

Statement of Linda Evans, Program Director, Taxes and Finance, 
Governmental Programs, IBM

    Mr. Chairman, Members of the committee, on behalf of IBM, I 
thank you for the opportunity to share our views on the 
importance of research and development in the context of the 
new economy and the role of the federal R&D credit. I am Linda 
Evans, Program Director Taxes & Finance for IBM Governmental 
Programs here in Washington D.C. Over the next few minutes, I 
will briefly touch on the impact of the Information Technology 
industry or (IT) in the emerging ``new economy'' and the 
critical role of R&D--the lifeblood for innovation and driver 
of the IT industry. I will then give some examples of IBM's 
technological and developmental innovations that benefit the 
lives of all Americans.
    As a key player in the IT industry, IBM strives to lead in 
the creation, development and manufacture of the IT industry's 
most advanced information technologies, including computer 
systems, software, networking systems, storage devices and 
microelectronics. IBM also has a worldwide network of solutions 
and services teams that translate these advanced technologies 
into value for its private and public sector customers.
    Key to IBM's success is its record of innovation which is 
made possible by investment in research and development. The 
federal R&D credit and its complement Alternative Incremental 
Research Credit or (AIRC), have proven to be a cost-effective 
means to increasing business research investment. I'll speak 
more about this in a minute.

The Power of the IT sector

    I think it fair to say that the high-technology sector and 
in particular, the information technology industry, has had a 
significant impact on the growth of the U.S. economy. According 
to a 1998 Department of Commerce study on ``The Emerging 
Digital Economy,'' the information technology (IT) industry has 
been growing at more than double the rate of the overall 
economy and it now constitutes 8.2% of GDP. The Commerce paper 
also found that IT has driven over one-quarter total real 
economic growth on average over each of the last five years.
    According to the Department of Commerce, business spending 
on IT in 1996 rose to 45 percent of total business investment 
as compared to only 3 percent of total business investment in 
the 1960s. Companies in the U.S. are now looking more and more 
to IT to increase productivity. Federal Reserve Board Chairman 
Alan Greenspan has said more than once that information 
technologies have had a positive effect on productivity growth 
in the U.S. In the area of employment, the Department of 
Commerce found that in 1996, 7.4 million people worked in the 
IT sector and IT-related jobs throughout the United States.
    The Department of Commerce study further concludes that IT 
and electronic commerce which are part and parcel of the 
emerging digital economy, will drive economic growth for years 
to come. According to one estimate, in the U.S., some $2.7 
trillion of business will be conducted on-line by 2004. On a 
worldwide basis it is said that this figure could hit some $7.3 
trillion in the same year. What is emerging is the rise of a 
new economy, and a new global medium, the Internet, that will 
perhaps be the single most important driver of business, 
economic and social change in the 21st century.

Research and Development: Lifeblood of Innovation

    To fuel continuing economic growth, productivity and bring 
other societal benefits, the high-technology sector and IT rely 
heavily on research and development. The highly-competitive IT 
industry must innovate to survive, and it must innovate 
quickly. You may have heard of the legendary Moore's Law named 
for Intel cofounder Gordon Moore which holds that the price/
performance of the integrated circuits etched onto silicon 
chips (microchips) processing capacity doubles every 18 months.

Federal R&D Credit

    With the enactment of the federal R&D credit in 1981, the 
government is supporting the view that research and development 
is essential for innovation and continued economic growth. The 
credit is a recognition of the positive role of government in 
facilitating a cost-effective way to increase business research 
investment. In 1999 the ``Taxpayer Refund Relief Act'' extended 
the credit for five years providing some of the predictability 
that industry has sought over nine years of annual renewals. 
For high-tech and IT companies, this is important because they 
generally budget R&D over five-to-ten year planning cycles. 
Also last year, the credit was strengthened by improvement in 
the Alternative Incremental Research Credit or the AIRC. The 
AIRC was created in 1996 for use by companies that could not 
benefit from the regular credit. Last year's changes to the 
AIRC have made it available to a greater number and variety of 
companies. For IBM, last year's extension and modification of 
the R&D credit and the AIRC have created a more positive 
environment.

IBM Innovation

    A testament to the value of R&D to IBM is the fact that for 
the seventh year in a row, the company earned more U.S. patents 
than any other company in the world. In 1999, IBM earned 2,756 
patents--900 more than the second-place company. In fact, over 
the decade from 1990 to 1999, IBM was awarded more patents than 
any other company, leading to a host of new products and 
services. The heart of IT is indeed innovation and for IBM it 
embraces processing, speed, storage and connectivity.
    IBM continues to seek ways to make computer technologies 
work faster and more effectively. This includes breakthrough 
chip-making processes that involve new materials to produce the 
next-generation of computer chips, the brains of computers. IBM 
has also led in the storage density area, by announcing in 
April of this year the densest drives ever for notebook 
computers. The drives have 15 times the capacity of the typical 
notebook drive and can hold the equivalent of a mile-high stack 
of documents or 49 music CDs. The drive spins at about 5,400 
rotations per minute, faster than most notebook drives and more 
like a desktop PC drive. As workers become increasingly mobile 
in the new economy, they'll need the convenience of portability 
and the computing power of a desktop workstation.

Solving Problems with IBM products and services

    ``Deep computing'' refers to the application of raw 
computing power, advanced software and sophisticated 
algorithms, and it is being used to analyze and solve 
increasingly complex environmental problems. For example IBM 
RS/6000 SP technology which also powers the supercomputers of 
the Lawrence Livermore facilities, is being used by the U.S. 
National Center for Atmospheric Research to calculate how 
thousands of variables interact. Such variables as ocean 
temperature, precipitation and ozone depletion can be analyzed 
and configured to better predict long-term climate change.
    The products and services generated by innovations in the 
IT industry embrace many facets of every day life in this 
country and in the world. In the interest of time, I will 
describe just a few of the areas of IBM's involvement:

Life Sciences and Health Care

    Many of you may recall Gary Kasparov playing chess against 
the powerful Deep Blue IBM computer. Today, IBM is 
participating in the next Grand Challenge, to simulate the 
folding of a complex protein. For this big initiative, IBM will 
build a supercomputer called ``Blue Gene'' whose power will be 
needed to unlock the code of some three billion chemical 
structures.

Electronic Commerce and E-business

    Estimating the number of current Internet users is not at 
all exact as there are a multitude of surveys, but according to 
one estimate, there are over 350 million users today and with 
so many new users getting on line each day, there will soon be 
over 500 million users. The Internet bridges geographic 
boundaries and IBM directs its (IT) in ways that leverage the 
power of the Internet to help small, medium and large 
businesses expand their global reach. The prospect of 
connecting a multitude of information systems and reaching 
whole new sets of users including employees, customers, 
suppliers and business partners, has given rise to what IBM 
refers to as ``e-business.'' This is a strategic priority for 
IBM and it refers to the broader, more powerful aspects of what 
is evolving: Now entities of all sizes in all industries, both 
private and public sector can redefine what they do and 
reinvent who they are. E-business applications and technology 
can transform internal operations including how products get 
developed, how work gets done and even how employees share 
ideas.

In the Area of Environmental Sciences

    IBM researchers have developed a weather modeling and 
visualization system to improve local weather forecasts and to 
more accurately predict local patterns as well as violent 
weather phenomena such as thunderstorms and wind shear. IBM's 
system called Deep Thunder provides local scale information and 
precision that can also be important in potential applications 
such as aviation, travel, agriculture and construction, where 
weather is an important factor in making decisions. The 
computing power, software advancements and simulation 
capabilities of IBM's technology are bringing better 
understanding and faster solutions to the world's scientific, 
medical and environmental problems.

In the Area of Education

    Improving K-12 and lifelong learning are important national 
concerns. Education is vital to a thriving economy and this is 
no less true for a new information-based economy. IBM has a 
strong history of, and commitment to, improving schools. The 
company works to provide technology and expertise to bring new 
teaching methods including IT and Internet-based methods that 
will facilitate and improve the way kids learn, and the way 
teachers teach. Through such technologies as data warehousing, 
knowledge management and distance learning, these programs 
extend and improve the availability and quality of education. 
Of course, a comprehensive discussion of education and its 
challenges goes well beyond computers in the classroom, and 
that discussion is outside the scope of our task here today.

                               Conclusion

    Well today, you will have heard from my colleagues and me 
about some of the ways our companies strive to innovate. You 
will have learned that innovation is a central focus of the IT 
industry and that we must innovate to survive. Research and 
Development fuels innovation and the federal research credit is 
an important tool in creating a positive environment for 
innovation.
      

                                


    Chairman Houghton. Thanks very much.
    Ms. Hutter?

STATEMENT OF COLLIE LANGWORTHY HUTTER, CHIEF OPERATING OFFICER, 
  CLICK BOND, INC., CARSON CITY, NEVADA, AND MEMBER, BOARD OF 
        DIRECTORS, NATIONAL ASSOCIATION OF MANUFACTURERS

    Ms. Hutter. Thank you, Chairman Houghton and members of the 
subcommittee for the opportunity to testify regarding the tax 
treatment of R&D. I am Collie Hutter, Chief Operating Officer 
and owner of a small 75-employee manufacturing company called 
Click Bond, Inc. We are located in Carson City, Nevada. As an 
owner of a company engaged both in performing R&D and applying 
the technological advances derived from R&D, I strongly 
advocate that the R&D tax credit be made permanent.
    By way of background, my undergraduate degrees is in 
physics from Carnegie Mellon University and I earned an MBA at 
the Wharton School of the University of Pennsylvania. Currently 
I am on the board of directors of the National Association of 
Manufacturers. I will share with you how R&D, applied in my own 
business, has produced technological advances that have kept my 
company growing.
    Since 1969, I have been a business owner of first a 
research and development company and now a manufacturing 
company that engages in considerable R&D. Click Bond designs 
and develops and manufactures fasteners, screws and nuts for 
the aerospace defense market. All of our fasteners are designed 
to be adhesively bonded for surface mounting. Click Bond's 
customers are primarily the aircraft manufacturers. We 
transformed from a pure R&D company to a manufacturing company 
in 1987 by default.
    At that time, we were unable to license the Click Bond 
technology to another manufacturer as we had been able to do 
with the other products we had developed. Since we strongly 
believed in this particular product line, we went into the 
manufacturing business ourselves. I suppose it might be said 
that my company moved backwards from being a new economy 
company, one based on high-tech equipment, intensive research 
and development and a skilled workforce, to an old economy 
company that employs less-skilled people. That is not true.
    Our skilled scientists and engineers are still doing their 
innovative work, but are more focused on one type of product. 
We like to think that we expanded our horizons by converging a 
traditional manufacturing company with technology to become a 
new manufacturer in the new economy. My company has benefited 
from the R&D tax credit in three ways: One, through direct use; 
number two, from the flow-down from our suppliers who utilize 
the tax credit; and indirectly through the high-tech products 
developed in use with the credit.
    The direct benefit is that a number of years ago I was able 
to use the credit and it was a sufficient amount of money for 
our company to apply for an additional patent. The major 
benefit we have is the flow-down benefit. The Click Bond 
fastening systems are possible because chemical companies, many 
of which use the R&D credit, have developed the high-strength, 
fuel-resistant, high-temperature epoxy and acrylic-modified 
adhesives that are used to bond our fasteners to the aircraft 
and other surfaces. These same chemical companies also 
developed and brought to market the high-strength plastics from 
which we make our fixtures that hold our fasteners in place.
    The credit encourages them to continue and to expand their 
research into new products. An indirect benefit we have of the 
research and development is that Click Bond uses the products 
developed and brought to the market by the new economy. These 
new-economy products provide the tools to control my 
manufacturing process, design my parts and increase the 
efficiency of my operation. For example, we use electronic 
micrometers that feed information directly to computers for 
statistical process control. Parts that flow in and out of our 
stock rooms are controlled by bar-coded bins. A materials 
resource planning program that runs on a Windows platform 
controls the movement of work-in-process through our factory.
    Many of our incoming orders are received via electronic 
data interchange. Our high-speed Internet access via T1 lines 
and Cisco routers was installed so we can efficiently purchase 
supplies over the Internet. Our lathes and mills have computer 
controls. You see, new-economy products support many aspects of 
my traditional manufacturing operation. High-tech and modern 
manufacturing are the same thing. Manufacturing today is, by 
definition, high-tech and the engine of the new economy.
    Currently it is fashionable to say that there is a 
distinction between the old and new economy. This distinction 
is without a difference. It is a false dichotomy. My company is 
a good example of this. Today manufacturers have many things to 
think about in addition to just getting their product out the 
door: EPA, OSHA, State regulations, personnel regulations, 
health insurance, to name a few. Large companies have the 
resources to employ experts in these areas, while small 
companies typically rely on the owner, like myself, to be the 
expert.
    A permanent R&D credit would reduce the number of variables 
we have to contend with in our long-range planning. Every R&D 
dollar spent is potentially at risk. The insurance that the R&D 
tax credit is there reduces the perceptible risk. It would be 
positive to know that the credit will be there when the R&D is 
complete. A permanent credit would be a powerful tool to fuel 
more R&D in our new economy. Not only my company, but also the 
many other companies large and small that are constantly 
juggling their limited supply of capital between intangible and 
tangible products would benefit from the permanent credit.
    Again, thank you for your indulgence of time. I will be 
happy to answer any questions.
    [The prepared statement follows:]

Statement of Collie Langworthy Hutter, Chief Operating Officer, Click 
Bond, Inc., Carson City, Nevada, and Member, Board of Directors, 
National Association of Manufacturers

    Thank you Chairman Houghton and members of this 
subcommittee for the opportunity to testify regarding the tax 
treatment of research and development (R&D) expenses at this 
hearing on the federal tax code and the ``new economy.'' I am 
Collie Hutter, Chief Operating Officer and owner of a small, 
75-employee manufacturing company, Click Bond, Inc, in Carson 
City, Nevada.
    As the owner of a company engaged both in performing R&D 
and applying the technological advances derived from R&D, I 
strongly advocate that the Research and Experimentation tax 
credit, commonly referred to as the R&D tax credit, be made 
permanent. Thank you in particular to those congressional tax-
writing committee members here today--which is many of you--who 
have supported the R&D tax credit, including most recently a 
multi-year extension. Specifically, I will comment on how R&D 
applied in my own business have produced technological advances 
that have kept my company growing.
    By way of background, my undergraduate degree is in Physics 
from Carnegie Mellon University and I earned an MBA at the 
Wharton School at the University of Pennsylvania. Currently, I 
am on the Board of Directors of the National Association of 
Manufacturers.
    Since 1969, I have been a business owner, along with my 
husband and brother-in-law, of first a research and development 
(R&D) company and now a manufacturing company that engages in 
considerable R&D. Click Bond designs, develops, manufactures 
and markets fasteners, screws and nuts for the aerospace/
defense market and other producers of end products that are 
made of composite materials. All of our fasteners are designed 
to be adhesively bonded for surface mounting. Click Bond is a 
wholly owned subsidiary of our R&D company, Physical Systems, 
Inc.
    Physical Systems holds approximately 20 U.S. patents on 
products that were successfully brought to the marketplace. The 
engineers and scientists at Physical Systems developed all the 
products covered by these patents. Ten of these patents cover 
the Click Bond product lines.
    We transitioned from a pure R&D company to a manufacturing 
company in 1987 by default. At that time, we were unable to 
license the Click Bond technology to a manufacturer, as we had 
been able to do with our other products. Since we strongly 
believed in the product concept, we went into the marketing and 
manufacturing business ourselves.
    I suppose it might be said that my company moved backwards 
from being a new economy company, one based on ``high tech 
equipment, intensive research and development, and a skilled 
workforce,'' to an ``old economy'' company that employs less 
skilled people. That simply is not true. My company would not 
have grown without using the technology developed in just the 
past decade. Our skilled scientists and engineers still are 
doing their innovative work, but are more focused on one type 
of product. We like to think that we expanded our horizons by 
converging a traditional manufacturing company with technology 
to become a ``new manufacturer'' in the new economy. Further, 
our workforce grew from seven to 75.
    Click Bond's customers are primarily aircraft manufacturers 
such as Boeing Commercial and Military, Lockheed Martin, 
Northrop Grumman, Airbus, British Aerospace, Bombardier and 
their suppliers. Twenty percent of our business is derived from 
exports and another 20 percent comes from domestic commercial 
customers such as boat builders, the automotive industry and 
the amusement park industry.
    Over the years, my company has benefited from the R&D tax 
in the following three ways: 1) through direct use of the 
credit; 2) from the flow-down benefits from our suppliers who 
use the credit; and 3) indirectly, through the hi-tech 
products, developed because of the tax credit, that are used in 
our manufacturing process and product innovations.

1) The Direct Benefit:

    My company took advantage of the R&D tax credit in 
initially developing the Click Bond product line. Although the 
credit was of a small monetary value, it was sufficient to 
allow us that one additional patent application. In one 12 
month period, we applied for and received three U.S. patents on 
our Click Bond product line. For a small, new company to enter 
a highly competitive market such as fasteners, it was of 
immeasurable benefit for us to have good patent protection for 
our innovative products.

2) The Flow-Down Benefit:

    Many large U.S.-based chemical companies take advantage of 
the R&D tax credit. The credit encourages them to continue and 
expand their research into new products. The Click Bond 
fastening systems are possible because these chemical companies 
developed the high strength, fuel resistant, high temperature 
epoxy and acrylic modified epoxy adhesives used to bond our 
fasteners to aircraft and other surfaces. These chemical 
companies also developed and brought to market the high 
strength plastics from which we make our fixtures that hold our 
fasteners in place while the adhesive sets. A small company 
such as Click Bond rarely performs primary materials research. 
Instead, we typically incorporate the materials and processes 
developed by the larger companies into our innovation programs. 
Also, we do intensive research into new materials being 
introduced to the market--especially those trends we see the 
primary research following. We will often develop products that 
need a material or process that has yet to be brought to the 
market, and we will have to wait to complete our development 
until the product is available on an economic scale.

3) Indirect Benefit:

    Click Bond is an excellent example of the integration of 
traditional manufacturing with the technological innovations of 
the past decade that have transformed our economy into what is 
now commonly referred to as the new economy. Manufacturing 
today by its very definition is high tech and the engine of the 
new economy. My company is a case in point.
    Click Bond uses the products developed and brought to 
market by the new economy. These new economy products provide 
the tools to control my manufacturing process, design my parts, 
and increase the efficiency of my operation. We have more than 
35 computers for 75 employees. Also, we have electronic 
micrometers that feed information directly to computers for 
statistical process control. Parts flow in-and-out of our 
stockrooms and are controlled by bar coded bins. A Material 
Resource Planning program that runs on a Windows platform 
controls the movement of work-in-process through our factory. 
Many of our incoming orders are received via Electronic Data 
Interchange. Our high speed Internet access via T1 lines and 
Cisco routers was installed so we can efficiently purchase 
supplies over the Internet. We are preparing to purchase 
materials for production over the Internet, too. Our lathes and 
mill are computer controlled.
    As you can see, new economy products support every aspect 
of my traditional manufacturing operation. High tech and modern 
manufacturing are the same thing. Currently fashionable is a 
distinction between the old economy and the new economy. This 
distinction is without a difference; it is a false dichotomy.
    Small companies are often the first to introduce a new 
material--or a new use for a material--because we can produce 
economically on the small scale required by a new product 
introduction. In the aircraft business, a product may be sold 
in small quantities for years before the market demands 
production on a scale that makes economic sense. An example of 
this is the all-composite screw that is essentially a screw 
made of reinforced plastic. These fasteners save weight, resist 
corrosion and do not conduct electricity. In short, they are 
excellent airplane parts.
    A number of companies have been looking at making various 
types of composite fasteners. A large company, spurred on in 
part by the R&D credit, started research into a composite 
screw. The company was able to get very close to a finished 
product, but determined that it could not economically justify 
production on the relatively small scale that would be required 
during what was proving to be a very lengthy introductory 
period. Click Bond was able to buy the project for cash and 
future royalties. We are working hard to improve the product 
through additional R&D, but also we have put their original 
product in production in our plant, where we can more easily 
justify the small production quantities.
    Based on my experience, I believe that the R&D tax credit 
is serving its intended purpose as an incentive to spur R&D 
that would not otherwise be performed. I applaud Congress for 
approving a multi-year extension of the credit last year, but I 
cannot overstate how the incentive value of the R&D credit 
would be enhanced exponentially if the credit were permanent. A 
permanent credit would be a powerful tool to fuel more R&D in 
our new economy.
    Today, manufacturers have many things to think about, in 
addition to just getting their product out the door. EPA, OSHA, 
EEOC, state regulations and the many rules and regulations 
relating to personnel, health insurance costs, to name a few. 
Large companies have the resources to employ experts in these 
areas while small companies typically rely on the owner to be 
the expert. A permanent R&D credit would reduce the number of 
variables we have to contend with in our long-range planning. 
Every R&D dollar spent is potentially at risk. The assurance 
that the R&D tax credit is there reduces the perceptible risk. 
It would be a positive to know that the credit will be there 
when the research is done.
    As a member of the small business community, it is a 
privilege to testify here today. If the R&D tax credit were 
permanent--which it should be--the credit's incentive value 
would be significantly enhanced for my company as well as many 
others. Not only my company, but also the many other companies, 
large and small, that are constantly juggling their limited 
supply of capital between intangible and tangible projects, 
would benefit from a permanent credit. My fellow NAM Board 
member Murray Gerber was quoted in Time last week (September 
25), citing another spillover benefit from the R&D tax credit. 
While he did not use the R&D credit himself, he doubts he would 
have received R&D contracts from his primary customer if that 
company did not use the credit. This is just another example of 
the spillover benefits from the R&D credit.
    In closing, I strongly urge you to make permanent the R&D 
tax credit. A permanent credit will encourage manufacturers, 
large and small, to continue performing the vital R&D that is 
necessary for creating the jobs of tomorrow and expanding upon 
our current economic prosperity. Again, thank you for the 
invitation to testify at this hearing. I will be happy to 
answer any questions you may have.
      

                                


    Chairman Houghton. Well, thanks very much, Ms. Hutter. I 
have got a couple of questions, but the question I have got is 
a personal one. Why did you ever think of leaving the 
Northeast?
    Ms. Hutter. I married somebody from California.
    Chairman Houghton. But ended up in Nevada?
    Ms. Hutter. And ended up in Nevada.
    [Laughter.]
    Chairman Houghton. And you went to Carnegie Mellon; is that 
right?
    Ms. Hutter. Yes, I went to Carnegie Mellon.
    Chairman Houghton. I see. Great. Wonderful. I don't know 
how Mr. Weller feels about this, but I know we have talked up 
here about the R&D tax credit and making it permanent. I think 
we all agree it is a good idea. The question is as we move into 
this new age of industrialization or information technology, 
what are those things which really should be covered by the R&D 
tax credit? It is a vast area. I mean, it goes from original 
research right down to quality control.
    Do you think that is right? Have we got the formula right 
for you all?
    Ms. Hutter. It is not my total area of expertise. I think 
the broader we can define it, if it is pure R&D, it really is 
going to eliminate many of the smaller companies, would be my 
feeling, because my company does do pure R&D, but I think--
    Chairman Houghton. More product and process work?
    Ms. Hutter. Right.
    Chairman Houghton. I see. But that would not apply to IBM 
necessarily; would it, Ms. Evans, when you are talking about 
the number of patents which you have applied for and been 
accepted, that is far beyond just the process and product work?
    Ms. Evans. Right. If I had to decide how much of the R&D--
about 15-to-20 percent of our R&D is basic and exploratory, and 
a lot of that is on the margin, sort of high-risk research and 
development. The others are project-driven, and the thing about 
the IT sector is that it is a highly-competitive one. You have 
to innovate and innovate quickly. You may have heard the 
expression of Moore's law, that the power of processing 
capability doubles every 18 months. Well, there are even new 
measures in the new economy referring to the ``network 
effects,'' because now everything is connected with computers 
and communication devices, so the speed is rather quick.
    So we have exploratory research, as well as project-
developed research; and the bulk of the R&D goes towards 
project research. I would say, of that, 50 percent is hardware, 
and the other half is in software development.
    Chairman Houghton. Well, you know, as you look out at the 
United States and the world economy, clearly we have got assets 
and we have got liabilities. One liability we have is wages. I 
mean, we just cannot compete with Sri Lanka or Indonesia or 
things like that. So, we have got to have new products; we have 
got to have new science; we have got to have new things coming 
along. So, the question of the R&D tax credit is, is it geared 
toward those new things rather than just sort of sustaining 
some sort of quasi-technical work which is done in firms? Maybe 
Mr. Capps or Mr. Sample would have comments about that.
    Mr. Capps. Yes, I think it is. Again, it is intentionally 
designed broadly, but what it results in is improvements in 
products, processes and capabilities across all industries, 
which ends up translating into productivity increases. I know 
that in the information technology industry, what IBM does, 
what EDS does, what Microsoft does, is to create the ability to 
use information and leverage off information in ways that were 
not possible 10 years ago.
    One person can do more than what one person could do back 
then; we are increasingly seeing that trend and have seen it 
help keep inflation down.
    Chairman Houghton. Can I just interrupt a minute? I agree 
with you, and you are expressing it much better than I, but I 
think the question I have is if you look over the next hill and 
see the science evolving as it is now, and you see the 
tremendous international competitive forces, is the Government 
and university and business community there--are we doing the 
right things for one another?
    We cannot create jobs, obviously; but we can create an 
atmosphere where those jobs are stimulated. The question is if 
you look at the R&D tax credit, is it really pointed towards 
those things which would create the new rather than just 
sustain something which has already been developed?
    Mr. Sample. Mr. Chairman, I think the R&D credit does a 
great job of focusing companies on technical innovations and 
creating more high-skilled jobs to enable our workers to 
compete with some of the other economies you have mentioned 
that are more competitive on a basic wage rate. It does that in 
a couple of ways. First, the research has to be in the 
technology area in order to qualify for the credit.
    Second, the research--
    Chairman Houghton. Research has to be in the technology 
area? Research has to be in the research area.
    Mr. Sample. But only in technology. It has got to be 
basically the physical sciences, and computer sciences. So, it 
has basically got to be physics, biology, chemistry or computer 
sciences. For example, social research, as important as that 
might be, does not qualify for the credit.
    Chairman Houghton. No, I understand.
    Mr. Sample. Second, in order to be eligible for the credit, 
the particular development project has to involve a process of 
experimentation, which means that companies have to try to do 
something with the research project that they currently do not 
know how to do. A significant element of the project has to 
involve trying to do things through a trial-and-error process 
that they do not know how to do. And, lastly, only a very 
narrow range of expenditures qualify for the credit. Primarily 
it is salaries and wages paid to people performing direct R&D 
activities.
    So, the credit focuses companies on doing technology 
research to learn things that they currently do not know how to 
do, and the only way they can continue to qualify for the 
credit is to increase their qualifying expenditures, which are, 
I think as a general matter for the R&D Credit Coalition 
companies, over 75 percent of the expenditures are for 
additional salaries and wages, and in my company it is over 90 
percent.
    Chairman Houghton. Good. Thanks very much.
    Mr. Coyne?
    Mr. Coyne. Thank you, Mr. Chairman. I would like to ask the 
panelists if the nature of your R&D at your companies is 
affected by the fact that you are on a four-year leash as it 
relates to R&D, as opposed to if it were permanent? Would the 
nature of your R&D change? Would it be different?
    Mr. Sample. Well, I do not think the nature of the R&D 
would change in that in order to have a successful R&D project, 
you are going to have to commit to making a long-term multi-
year investment in product development. The impact of making 
the credit permanent would basically increase the incentive 
that is provided by the R&D credit for companies to do even 
more R&D than they are doing now.
    Mr. Coyne. Does anyone else want to comment?
    Mr. Capps. It affects your ability to model a benefit 
currently for more than four years, next year for more than 
three years. At EDS, most of our research projects are multi-
year projects, so that becomes an issue. You cannot outlook the 
full benefits, so you are not getting the full bang for the 
buck.
    Mr. Coyne. Did you want to comment?
    [No response.]
    Mr. Coyne. Okay. I wonder if you could comment on how real 
or unreal is the problem we hear so much about, businesses not 
being able to find and hire trained workers to do the necessary 
work that the corporations have to do?
    Mr. Capps. Yes, I think it is a very real issue. I think we 
are already seeing that and experiencing it in the information 
technology industry. I don't know what the exact numbers are, 
but I have heard we have over one million unfilled positions as 
I am speaking to you. Those are good positions, high-skill, 
high-paid positions and there are not the people to fill them.
    They are projecting that number is on the order of 
magnitude of four million unfilled positions by 2004. So, it is 
a real issue. It is an immediate issue. We are facing that 
today.
    Mr. Coyne. How about IBM and Microsoft and Mrs. Hutter's 
company?
    Ms. Evans. We are experiencing the same thing; and clearly 
in the area of science and engineering, it has not been really 
as great a focus in this country, certainly at the K-12 level. 
We are finding a shortage of people in those skills in this 
country and we have had to use the H1B visa program to fill 
those jobs. I also don't know the numbers, but it is very real 
in the IT sector where the skills required are increasing 
exponentially as the technology changes. So, it is a problem.
    Ms. Hutter. I just want to follow-up that that is a 
problem, even though the level that we are working on obviously 
is much different. Even in our small company, we have three 
vacancies in our engineering department--and also the caliber 
of engineers--maybe an example of my getting old, but some of 
these young people coming out of the schools, they know an 
awful lot about computers, but they don't know what they are 
looking at on the screen. They have never actually gone out and 
had to make something, and that is one problem that we are 
seeing.
    Mr. Sample. It is probably one of the most important issues 
facing our company as we look to how we are going to continue 
to succeed and grow. I think we ended our last fiscal year with 
over 4,000 unfilled permanent full-time positions, and I think 
we are going to plan to hire another 4,000-plus this year. I do 
not know where we will be able to find them. The increase in 
the high-tech economy in the Puget Sound area, as well as in 
the Nation as a whole, means we are competing now with 
RealNetworks, with Amazon, a lot of high-tech companies, and we 
just can't find the people to fill the jobs.
    Mr. Coyne. Does this extend to the floor workers, people 
working on the floors of the factories, or is it just the 
engineers and high-tech and computer science engineers and 
technicians?
    Mr. Sample. Well, in our company, very few of our employees 
are involved in the operation side. Most are development, sales 
and marketing, technical jobs. It extends across the board, 
though.
    Mr. Capps. Yes, I think the numbers I was throwing out are 
more for the skilled workers that have a higher level of 
education and training, but I think we are starting to see 
strains on even the lower end of the workforce. And so it is a 
broader issue, I think. It goes deeper.
    Ms. Evans. I would agree with my colleagues. The upper end 
is probably where the greatest shortage is, but it is starting 
to be apparent at the lower levels, too, of lower-skilled 
people in our industry.
    Mr. Coyne. Thank you.
    Chairman Houghton. Ms. Dunn?
    Ms. Dunn. Thank you, Mr. Chairman. It has been a 
fascinating panel. It is interesting as we reach out--I don't 
see what is wrong with moving to the West, Mr. Chairman. I 
think moving to the West is a good thing. There is a lot of 
appeal in beautiful States like Nevada and Washington.
    Chairman Houghton. Well, you are outvoted two-to-one.
    [Laughter.]
    Ms. Dunn. I will bring my support troops. I want to 
especially welcome Mr. Bill Sample of Microsoft, who, in my 
neck of the woods, certainly has done as much as any company in 
the Nation, I am sure in the world, to educate people on a 
variety of tax issues and tax-related issues, taxation on the 
Internet, this issue we are talking about today, R&D credits, 
which I have never found anybody who doesn't agree that we 
should have permanent R&D credits. This is just a monolithic 
movement over the last few years and a frustration when we 
couldn't get it made permanent last year. We could get it to at 
least cover the next five years.
    So, it is something that I know is very important and you 
have a great support group here in the Congress, if we can make 
sure we find the money to fund it. I wanted to just ask a very 
practical question that would help me to imagine the practical 
effects of the unpredictability if the R&D credit is not made 
permanent. In the last few years, it has been for fewer than 
five years. In some cases, I think we have gone past the 
deadline and we have had to do a catch-up R&D. What actions do 
your companies take in order to deal with this unpredictability 
and what kind of costs do you incur? What can we use in talking 
about this issue that is real-life, from the front lines, to 
help us bring on the folks who don't understand the value of 
the R&D tax credit?
    Mr. Sample. Thank you. Well, as I said, our R&D projects 
are planned years in advance and at a minimum we spend probably 
three-to-five years on a particular product. Windows 2000, 
which we released last fall, began development in the mid 
1980s. So, every year, when we go through our budget cycle, we 
have to make commitments to projects which our level of effort 
we know is going to have to be maintained years into the 
future.
    In the 1980s, I think the financial people in our industry 
were more willing to rely on extensions of the R&D credits when 
looking out over two, three, four-year time horizons. But, in 
1995, the credit lapsed and it was not extended until the 
following year and there was a twelve-month gap where there was 
no credit. After that twelve-month gap, I don't know any tax 
professional that would recommend to their CFO to count on the 
credit beyond the extension period, 1995 to 1996--there was a 
twelve-month gap. And, so, I think it is more critical now 
after the 1995-to-1996 gap than it ever has been to make the 
credit permanent.
    Ms. Dunn. Does anybody else wish to comment on the cost to 
your company or your business plan as you see that there is 
some unpredictability?
    Mr. Capps. I think our experience at EDS has been similar 
to what Bill described at Microsoft. Before we had the gap, I 
was predicting with more confidence that the credit would be 
extended and recommending that our people recognize that and 
take that into account. But, since that, I would discount that 
a certain amount and it just hasn't carried the same weight 
that it would if it was permanent.
    Ms. Evans. In the case of IBM, certainly long-term planning 
is critical and we would experience the same thing. So, to the 
extent that you have a sufficient horizon for these projects, 
some of which I talked about earlier, tapping some major 
medical and environmental issues, it is difficult for you to be 
able to plan and predict when you have these long-term 
projects. So, it is a problem for us.
    Ms. Hutter. I think a pervasive argument, even in the small 
companies, is that R&D is inherently risky and you are now 
having an additional risk of a credit that you are counting on 
that is supposed to be your incentive is also a risk--in other 
words, it is just a multiplier. And I think for us it is just 
you can't count on it, and that makes another uncertainty, 
which tends to take money away from that type of work.
    Ms. Dunn. Let me just ask one brief question, Mr. Chairman. 
The R&D can only be applied to research and development done in 
the United States. How extensive is that credit? Are you 
finding your companies are restricting R&D to the United States 
because the credit means enough to you or are you going 
overseas?
    Mr. Sample. Well, every year over the past several years, 
we have been increasing our R&D spending in the U.S. by 
probably three-quarters-to-a-billion dollars a year and 
probably adding several thousand R&D heads a year. So, every 
year the management at Microsoft has to decide where to make 
that incremental investment and other jurisdictions compete for 
our R&D investment. And one of the ways they compete is by 
making it cost-attractive in a variety of ways, including 
offering tax incentives.
    Our management is keenly aware that the R&D credit can 
reduce the cost of our doing research in the United States by 
about five-to-six-and-a-half percent on qualifying 
expenditures. I can tell you that is a big enough number to get 
the attention of our senior management all the way to the top. 
There is really only one tax issue I get e-mails from our 
chairman about, making sure it is still around, and that is the 
R&D credit.
    Mr. Capps. At EDS, the majority of our research is done in 
the U.S. We have had some intense pockets of research outside 
the U.S. We acquired a company a number of years ago that had a 
research group in England, and we have continued that. We did 
some research through a joint venture up in Canada. Both those 
jurisdictions had incentives for research that were attractive.
    As we go forward--we are in a very competitive global 
environment-- all these things come into play and you look at 
the cost of a labor force, the tax regime. All those things 
work into the model as far as where are you going to put 
various operations and where are you going to grow. So far we 
have been fortunate in being able to maintain the bulk of our 
R&D here, but that is a growing issue. A lot of countries offer 
very attractive financial and tax incentives to locate research 
there.
    I think the OECD recently did a study looking at nine 
countries, and saw the U.S. as third from the bottom as far as 
the relative incentives that it was providing.
    Ms. Evans. I wouldn't say we do R&D in this country because 
of the credit, because 85 percent of our research and 
development is done in the United States and that is the legacy 
of our starting off in New York with the Watson Laboratory, 
which is the main laboratory, and it cooperates with our 
laboratory in Almaden, California, and then there are other 
labs around the country.
    But over 85 percent of our research and development is done 
in this country and the fact that the credit does benefit U.S. 
research is helpful, but it is not a reason that we do it here 
in this country.
    Chairman Houghton. Just one final question. IBM has a large 
research laboratory in Switzerland. Do you get tax credits in 
Switzerland for R&D?
    Ms. Evans. I do not know the answer to that. I can find 
that out.
    Chairman Houghton. It is not important. Well, look, thank 
you very much. I certainly appreciate it. The meeting is 
adjourned.
    [Whereupon, at 11:44 a.m., the hearing was adjourned.]
    [Submissions for the record follow:]

Statement of American Textile Manufacturers Institute

    The American Textile Manufacturers Institute (ATMI) 
welcomes the opportunity to include the following comments in 
the record of the September 26, 2000 hearing held before the 
House Ways and Means Subcommittee on Oversight with respect to 
the tax code and the new economy. ATMI will focus its comments 
on the Treasury Department's analysis of cost recovery 
provisions in its recent Report to Congress on Depreciation 
Recovery Periods and Methods (``Report on Depreciation'').
    ATMI is the national trade association for the U.S. textile 
industry. The ATMI Tax Committee, which developed the 
information and proposals contained in these comments, consists 
of several dozen tax executives from various ATMI member 
companies of all sizes.
    Since the American textile industry is a capital intensive 
industry, ATMI has historically taken a great interest in tax 
depreciation policy. For example, ATMI worked closely with 
Treasury representatives in the early 1960's in the development 
of the Rev. Proc. 62-21, 1962-2 CB 418, which established the 
Class Life System, and then in the late 1960's and early 1970's 
with Congress and the Treasury in the enactment and 
implementation of the Asset Depreciation Range System (ADR) for 
assets placed in service after December 31, 1970. We also have 
taken an interest in the enactment and implementation of both 
the Accelerated Cost Recovery System (ACRS) and the Modified 
Accelerated Cost Recovery System (MACRS).
    We are pleased that Congress is again studying the recovery 
periods and depreciation methods under Section 168 of the 
Internal Revenue Code. As you are undoubtedly aware, there has 
been no change in class lives since 1981, and further, there 
has been no significant change in depreciation policy by 
Congress since MACRS was established in 1986.
    Upon review of the Treasury Department's Report on 
Depreciation, we cannot help but conclude that the time-
consuming and expensive studies proposed by the Treasury 
Department may not be necessary at all in connection with your 
efforts to improve upon the nation's system of recovery periods 
and depreciation methods under section 168. ATMI submits that 
Congress could more efficiently promote the creation of capital 
in the United States by implementing some or all of the 
proposals detailed below without the necessity of engaging in 
the lengthy and expensive studies suggested by the Treasury 
Department.

The Importance of Tax Depreciation Policy to the Textile 
Industry

    As noted above, the American textile industry is a capital 
intensive industry and as a consequence capital recovery 
depreciation policies are of paramount interest to it. We 
currently spend over $2 billion annually in capital investment 
in order to modernize our plant and equipment, which is 
absolutely essential for our companies to remain competitive in 
the global economy.
    In addition, there are two other factors regarding the 
textile industry that we believe should be given consideration 
by Congress in connection with any modification of Section 168.
    The first of these two factors is that special attention 
should be given to aiding struggling industries, particularly 
those industries such as steel and textiles (which are so 
critical to our national defense and to our overall economy) 
that must compete with surging imports from countries that 
provide a much more supportive environment to their industries.
    The textile industry averaged only 2.28% profit on sales 
and 3.34% profit on assets over the period from 1987 through 
1995. This compares to an average of 4.10% profit on sales and 
an average 4.52% profit on assets over the same period for all 
manufacturing companies (including textile companies). For the 
most recent years, the profitability of the American textile 
industry has fallen even further behind the average as shown by 
the following schedule:



                                           U.S. Textile Industry                  All U.S. Manufacturers

                                    Return on Sales    Return on Assets     Return on Sales    Return on Assets

    1996                                       2.6%                3.8%                6.1%                6.5%
    1997                                       2.8%                4.0%                6.3%                6.6%
    1998                                       3.2%                4.3%                6.0%                6.0%
    1999                                       1.3%                1.6%                6.2%                6.1%



    Much of this poor performance of the American textile 
industry in even boom times is attributable to the rapid 
acceleration of imports. The following table tracks the growth 
in textile and apparel imports (measured in square meter 
equivalents --SME) to record levels for each year during the 
period of 1989 through 1998:

          Growth of U.S. Textile and Apparel Imports, 1989-1998
------------------------------------------------------------------------
                                    Imports (sme in    Change from prior
              Year                     billions)             year
------------------------------------------------------------------------
1989............................             12.144             +13.01%
1990............................             12.195              +0.42%
1991............................             12.800              +4.96%
1992............................             14.521             +13.45%
1993............................             15.846              +9.12%
1994............................             17.286              +9.09%
1995............................             18.308              +5.91%
1996............................             19.063              +4.12%
1997............................             22.895             +20.10%
1998............................             25.945             +13.32%
1999............................             28.615             +10.29%
------------------------------------------------------------------------

    The plight of the textile industry can be demonstrated by 
many other objective measurements. Textile employment has been 
declining for many years and declined at rates that exceeded 
productivity growth in each of the years 1993 through 1998. 
Plant closings are now a common occurrence in the American 
textile industry. Yet another objective measurement is the 
precipitous decline in the market value of shares of most 
publicly traded American textile companies in the face of a 
roaring bull market.
    The second factor is the normal wear and strain placed on 
textile machinery by the long and continuous hours of operation 
of most textile machinery. When business conditions permit, 
textile machinery is operated continuously 24 hours a day, 
seven days a week (minus normal downtime for routine 
maintenance). This, of course, can shorten the life of this 
machinery.
    We submit that these factors support one or more of the 
proposals outlined below as being particularly important for 
the textile industry. However, we understand that any 
legislation may not be industry specific and we submit these 
proposals for general consideration as well as for targeted 
relief for struggling industries such as the American textile 
industry.

Depreciation Proposals of ATMI

    The goals of our proposals are to allow more rapid recovery 
of the costs of machinery, equipment and buildings, to further 
simplify tax depreciation procedures, and to aid struggling 
American industries so that they can better compete against 
imports that have become even more damaging, especially because 
of surges from Asian countries whose currencies have devalued 
over the past several years. To accomplish these goals, we 
propose the following modifications in MACRS (and to the extent 
relevant in ACRS):
    1. Replace the 200 percent declining balance method with a 
300 percent declining balance method as the general applicable 
depreciation method under Section 168(b). This proposal 
recognizes that depreciable lives have not been reconsidered in 
many years and that technological advances have greatly 
accelerated during this period, rendering much of the old 
technology obsolete. It permits this adjustment to be made 
without the delay, expense and complications that would result 
in undertaking an industry by industry, machine by machine 
study. If not adopted generally, we propose this change for 
capital intensive industries that are facing increasingly 
intense competition from foreign companies that enjoy more 
favorable tax regimes.
    2. Allow a certain percentage of the cost of depreciable 
property to be expensed in the year in which such depreciable 
property is placed in service. The portion not expensed would 
then be depreciated in accordance with Section 168, or 
preferably depreciated under Sec. 168 as modified by our first 
proposal. This proposal is a simplified approach to account for 
the inflation factor in replacing depreciable property and to 
reflect accelerating obsolescence and increased use of such 
property. As in the case of other of our proposals, if not 
adopted generally, this proposal should be targeted to 
distressed industries. We proposed that the percentage expensed 
be at least 20%.
    3. The establishment of a deductible repair allowance that 
would permit the taxpayer a deduction for actual repair 
expenditures not to exceed 20% of the unadjusted cost basis of 
property in each applicable recovery period category (see Sec. 
168(c)). One of the most common items of controversy in the 
audit of tax returns of manufacturing companies is whether 
expenditures made with respect to machinery, equipment and 
buildings are ordinary repairs and maintenance expenses that 
are deductible under Sec. 162, or are capital improvements that 
must be capitalized under Sec. 263. Under the ADR system, an 
annual asset guideline repair allowance percentage was provided 
and, if the taxpayer elected, expenditures that might otherwise 
be classified as Sec. 162 or Sec. 263 expenditures could be 
deducted to the extent of the applicable percentage. See Rev. 
Proc. 77-10, 1977-1 CB 548 (the repair allowance percentage for 
textile machinery was in four main categories: 22.2-16%, 22.3-
15%, 22.4-7% and 22.5-15%). Unfortunately, this statutory 
repair allowance percentage was not continued under ACRS or 
MACRS and, consequentially, the old item by item audit disputes 
resumed and, if anything, has been accentuated by Indopco, Inc. 
v. Commissioner, 112 S. Ct. 1039 (1992). See Rev. Rul. 94-12, 
1994 -1 CB 565.
    In fact, the failure of ACRS and MACRS to provide a repair 
allowance procedure seems incongruous in view of the fact that 
these systems address all of the other items that had been 
sources of dispute and conflict under general depreciation 
methods ( e.g., lives, rate of depreciation, method of 
depreciation, salvage and time of placement in service).
    We recommend a 20% allowance because it is somewhat higher 
than the percentage allowance under ADR (see Rev. Proc. 77-10, 
supra), which proved to be inadequate in practical experience 
in our industry.
    4. With respect to buildings, we propose that capital 
improvements to buildings be depreciable over a period of years 
that is no longer than the remaining depreciable life of the 
building. Under this proposal, in the typical situation when a 
capital improvement is made to a building (e.g., replacement of 
a roof) a taxpayer would have the option of adding such 
improvement costs to the adjusted basis of the building so that 
it would be depreciable over the remaining life of the 
building.
    5. While we have no precise proposal, we recommend that 
Congress reconsider and shorten the lives of buildings used in 
manufacturing.
    6. We recommend that consideration be given to providing 
shorter lives for used property.
    7. Under all circumstances and in all events, we propose 
that the alternative minimum tax, if not entirely repealed, be 
modified to eliminate depreciation as an adjustment in 
computing AMT income ( i.e., repeal Sec. 56(a)(1)) and also in 
calculating the adjustments for corporations based on adjusted 
current earnings under Sec. 56(g). These AMT provisions greatly 
complicate the preparation of corporate returns even where no 
AMT is due. They require that the taxpayer maintain an 
additional and separate depreciation system. Where these 
adjustments do cause AMT liability, the result is to undermine 
the policy of Sec. 168. We believe that allowing AMT to 
undermine Sec. 168 is bad tax policy. We urge Congress to 
eliminate (or modify) depreciation as an adjustment in 
computing AMT. (We recognize that these AMT proposals raise 
issues regarding adjustments under Sec. 481 and/or in modifying 
Sec. 53 credits.)
    8. Finally, we recommend that Congress authorize the 
Treasury Department to enter into depreciation agreements with 
any industry. This could allow an industry to perform 
depreciation analysis using a reasonable method of estimation. 
If this study followed specific procedures and those procedures 
were reviewed by Treasury, then the assets' class lives could 
be changed administratively. This method could be implemented 
by an ``Advance Depreciation Agreement,'' on a basis similar to 
advance pricing agreements under Sec. 482.
    We look forward to working with you to address any 
technical points concerning any of our proposals.

Conclusion

    We commend Congress for undertaking this needed 
comprehensive study of the recovery periods and depreciation 
methods under Sec. 168. We would welcome the opportunity to 
meet with Committee Members and staff, both to discuss our 
proposals and also to learn from you of other proposals being 
considered in order that we might have an opportunity to 
comment.
      

                                


Statement of Henry George Foundation of America, Columbia, Maryland

           A National Tax Can PROMOTE Economic Growth & Jobs

    THE PROBLEM--The electorate is enamored of government 
programs despite the taxes needed to finance them. That can 
only be changed if the government can come up with a revenue 
tax that actually promotes economic growth and jobs.
    THE SOLUTION -Fortunately, there is such a tax. We can 
start funding the government with a tax on land values. If that 
tax is increased, land values will not be decreased. A tax on 
land values would then replace national taxes on production.
    THE MORAL ASPECT--Workers and businessmen are entitled to 
all they produce; if you produce something, it's yours. Then 
there's nothing left for the landowner to justifiably own. No 
human being ever produced the land. If landowners (or 
slaveowners) get something for not producing, then workers and 
businessmen get less than what they produced. Landowning can no 
more be justified than slaveowning. Tax the one, abolish the 
other.
    ECONOMIC BENEFITS--When we tax production, we have less 
production. When we tax land values (or the annual imputed and 
actually-collected land rent) then land-sites must be more 
efficiently used (which by itself also means more production). 
So--tax land values, not things produced. If this is done, 
we'll have economic growth and more jobs, and yet the 
government can gets the revenue it needs. As a bonus, most 
voters would get tax reductions (since they own little valuable 
land).
    EMPIRICAL SUPPORT--All 17 studies of the twenty 
jurisdictions which have already adopted the two-rate tax show 
that spurts in new construction and renovation follow two-rate 
adoption within three years, and these two-rate jurisdictions 
have always out-constructed and out-renovated their nearby 
comparable one-rate neighbors. All independent studies by 
university researchers fully corroborate these 17 studies.
    IMPLEMENTATION--In the first year, each state should levy a 
surtax of 3% of its assessed land value and remit the revenue 
thus collected to the national government, who will then use 
the revenue to replace a particular tax on production which it 
is already levying, such as part of the income tax. The U.S. 
Congress used this type of revenue tax four times in the past--
in 1798, 1813, 1815 and 1861; the Constitution allows it. It 
can also establish a Federal Equalization Board.
    Tax Land Value Not Production Tax Land Value Not Production 
Tax Land Value Not Pro
      

                                


                        International Franchise Association
                                             Washington, DC
                                                    October 6, 2000
The Honorable Amo Houghton
Chairman, House Ways and Means Oversight Subcommittee
1136 Longworth House Office Building
Washington, DC 20515

    Dear Chairman Houghton:

    The House Ways and Means Oversight Subcommittee recently held a 
hearing to review the Treasury Department Report to Congress on 
Depreciation Recovery Periods and Methods. Although the International 
Franchise Association (IFA) was unable to provide testimony at the 
hearing, I would like to submit our comments for the record.
    IFA believes that the Treasury Report substantiates our belief that 
depreciation schedules in general need to be modernized, and we are 
encouraged by some of the findings in the study including: . . . that 
``the current depreciation system is dated''. . . that ``the asset 
class lives that serve as the primary basis for the assignment of 
recovery periods have remained largely unchanged since 1981''. . . and 
that ``entirely new industries have developed in the interim.'' We 
believe that these points speak directly to the need to address 
depreciation schedules for franchised real property.
    The International Franchise Association (IFA) serves as the voice 
of franchising both domestically and internationally. We represent both 
franchisors and franchisees and our membership includes more than 800 
franchise concepts in 75 different industries--from quick service 
restaurants to lawn care, to maid service and photo development. 
Franchising, as a concept, ties the spirit and ingenuity of local small 
businessmen and women to the advantages of a national brand name, 
accessible investment capital and an established marketing platform.
    When depreciation schedules were last updated about 20 years ago, 
franchising was certainly a viable business concept, however it was not 
the economic engine that it is today. Today, franchising accounts for 
$1 trillion in U.S. retail sales and more than 8 million jobs. Today's 
business climate now has more than 75 different industries that utilize 
the franchise business format. By shortening the depreciation schedules 
for franchises, Congress would not only allow the tax code to recognize 
this leading segment of our economy, but also to better reflect the 
true economic life of franchise assets.
    Current law requires franchisees to depreciate their real property 
over a 39-year period. However, the typical franchise agreement between 
a franchisor and franchisee specifies ownership for only a 15 or 20-
year period. (In some cases, the contracts are renewed, but only under 
terms that are then current.) These contracts also frequently require 
franchisees to undergo expensive refurbishments every 5 to 7 years. 
Under current law, these very common redecorations and upgrades must 
also be depreciated over a 39-year period. Also, improvements to 
leaseholds, which typically have a length of 7 to 10 years, also must 
be depreciated over a 39-year period.
    On behalf of our more than 30,000 member franchise outlets across 
the country, we urge Congress to take the necessary steps to modernize 
franchised real property depreciation schedules.
    We urge Congress and we thank you for holding your Oversight 
Subcommittee hearing on this important issue.
            Sincerely,
                                        Brendan J. Flanagan
                                   Director of Government Relations
      

                                


    Study on the Effects of Depreciation on the PWB and Electronics 
                          Assembly Industries

Executive Summary

    Printed wiring boards (PWBs) and printed wiring assemblies 
(PWAs) form the foundation for virtually all electronic systems 
in the world. They are the backbone of all computer and 
electronic products. Not only are they essential to all 
electronic products, they are vital to the changing technology 
in the automotive, communications, consumer products, computer, 
government and military, industrial and medical markets.
    The United States is struggling to remain a global leader 
in the face of strong international competition. In 1984, the 
United States owned 40 percent of the world market. Since that 
time, however, U.S. share of the world market has eroded. By 
1999 the United States held only a 26-percent share, with Japan 
in the lead at 29 percent. Other Asian producers, with Taiwan 
moving up very quickly, accounted for 23 percent of world 
production. Absent any policy or overall economic change, this 
downward trend is likely to continue.
    Another area where the U.S. industry lags behind its 
foreign competitors is cost recovery. Most foreign competitors 
recover a greater percent of asset costs in the first year, 
thus placing U.S. companies at a competitive disadvantage. As 
electronic equipment becomes more technologically advanced and 
the pace of technological innovation quickens, additional 
investment becomes necessary. This new investment is relatively 
more costly to U.S. companies than to offshore competitors.
    The Congress modified depreciable service lives many times 
since the early 1950s. The last modification, however, was 
nearly 15 years ago. In fact, many service lives have remained 
unchanged for more than 20 years. In the PWB and PWA 
industries, the past 20 years have been characterized by 
sweeping technological, organizational and competitive changes. 
Previous Congressional intent indicated a need to keep 
depreciation policies consistent with economic pressures. 
Clearly, depreciation policy has not kept pace with the 
technological change and economic pressures facing the PWB and 
PWA industries.
    The current proposal to reduce from five to three years the 
service lives of equipment in the PWB and PWA industries would 
provide this necessary and overdue change.

Industry Overview

    Electronic interconnects form the foundation for virtually 
all electronic systems in the world. They are the backbone of 
all computer and electronic products. Printed wiring boards 
(PWBs) and printed wiring assemblies (PWAs) connect and house 
other electronic components, integrating the entire circuitry 
of all electronic products. Without electronic interconnects, 
these products would not function.
    PWBs and PWAs are essential to not only all electronic 
products, but are also vital to innovative technology in the 
automotive, communications, consumer products, computer, 
government and military, industrial, and medical markets.
    To the average consumer, the words ``electronics industry'' 
conjure an image of large corporate businesses, such as 
Hewlett-Packard, AT&T, IBM and others. These large firms, known 
as original equipment manufacturers (OEMs), produce the 
finished electronic product. OEMs are, however, only one 
portion of the electronics industry. The electronic 
interconnect industry, comprised of both the PWB and PWA 
sectors, supplies products and services critical to OEMs. PWB 
and PWA growth depends, therefore, upon OEM growth.
    As OEM firms experienced rapid growth in the 1980s, they 
began to rely more heavily on the PWB/PWA sectors for inputs to 
their manufacturing processes. Emerging product shortages from 
abroad and rising production costs domestically reinforced this 
trend. This drove OEMs to shift portions of their fixed and 
operating costs to other firms. PWB/PWA firms became cost-
effective suppliers of quality interconnect products, helping 
to alleviate product shortages prevalent in the electronics 
food chain. Over time, PWB/PWA firms expanded their production 
processes to include product testing, design, and development, 
further elevating their importance to the electronics industry 
as a whole.
    Today, the PWB/PWA sectors remain a vital part of the 
electronics industry. With advances in technology occurring 
rapidly in other industries, the demand for high-density 
electronic interconnects is ever increasing. Industries such as 
the automotive, computer, telecommuni-cations, consumer, 
medical, and aerospace industries have introduced more 
electronic equip-ment and components in their products and, 
consequently, have high demand for interconnect products. While 
news of brisk product demand is a favorable condition facing 
PWB/PWA manufacturers, they face significant economic pressures 
that hamper their ability to meet such demand.

International Markets

    The U.S. printed wiring board industry remains a global 
leader, despite facing strong international competition. In 
1984, U.S. industry owned 40 percent of the world's PWB 
market.\1\ Since that time, however, the U.S. market has 
experienced a steady decline in world market share as a result 
of growing international competition.
---------------------------------------------------------------------------
    \1\ Interconnection Technology Research Institute, Technology 
Issues facing the Industry, October 1999.
---------------------------------------------------------------------------
    In 1999 Japan was estimated to have 29 percent of the world 
market for rigid printed wiring boards, with the United States 
next at 26 percent. Other Asian producers came in at 23 
percent, with Europe (14 percent) and all others (8 percent) 
accounting for the rest. Taiwan has greatly expanded its PWB/
PWA capacity and is challenging U.S. industry for market 
leadership.
    Japan's dominance is attributable to lower costs in labor, 
raw materials, environmental protection and safety compliance. 
In addition, the U.S. industry lags behind Japan in the use of 
automated process improvement techniques and in some technology 
areas including design-tool development, implementation, and 
usage.\2\
---------------------------------------------------------------------------
    \2\ USITC, Advice Concerning the Proposed Modification of Duties on 
Certain Information Technology Products and Distilled Spirits, Report 
to the President on Investigation No. 332-380, Publication 3031, April 
1997.
---------------------------------------------------------------------------
    Another area where the U.S. industry lags behind its 
foreign competitors is in the tax treatment of capital goods. 
Foreign countries, Japan most noticeably, are able to recover a 
higher (up to 80) percent of capital costs in the first year of 
service.\3\
---------------------------------------------------------------------------
    \3\ Data reflected in this graph do not account for differences in 
the overall tax regime of the country. However, for supporting evidence 
of international comparisons see ``Report of the Technical Committee on 
Business Taxation,'' Ministry of Finance, Canada, 1998.

[GRAPHIC] [TIFF OMITTED] T8411.009


    As the graph indicates, major foreign competitors recover a 
greater percent of asset acquisition costs in the first year, 
thus placing U.S. firms at a disadvantage relative to those 
competitors. Discrepancies in the cost structure of foreign 
business and the associated tax treatment raise issues of 
international competitiveness. To the extent that these 
differences arise from domestic policies that the federal 
government can modify to enhance U.S. competitiveness, 
businesses are concerned with these differences. In response to 
these concerns, legislative changes focused on leveling the 
playing field have been the subject of numerous domestic trade 
---------------------------------------------------------------------------
and tax proposals.

Domestic Markets

    U.S. companies producing PWBs and PWAs had shipments of 
$9.6 billion and $25.6 billion, respectively, in 1997.\4\ 
According to the 1997 Economic Census, employment in the PWB, 
PWA and supporting industries is approximately 250,000.\5\
---------------------------------------------------------------------------
    \4\ Data from US Department of Commerce, Economic Survey, 
Manufacturing Industry Series, EC97M-3344G; EC97M-3344H(revised); and 
EC97M-3344B; 1997.
    \5\ Ibid., Includes the related interconnect industry (NAICS 
334417; EC97M-3344G; 1997.
---------------------------------------------------------------------------
    The 1997 Economic Census Survey of Manufacturing reports 
657 and 1,315 companies involved in the manufacture of PWBs and 
PWAs, respectively. These figures are consistent with Market 
Research division of the IPC (Association Connecting 
Electronics Industries). Based on extensive membership surveys 
and statistical analysis, the IPC reports that the industry is 
comprised of mostly small businesses, with approximately 90 
percent having shipments of less than $10 million each in 
1998.\6\
---------------------------------------------------------------------------
    \6\ IPC Study of Financial Benchmarks for 1997 and IPC Assembly 
Market Research Council, The 1998 Market for Electronics Manufacturing 
Services Providers/Contract Assembly Companies.

[GRAPHIC] [TIFF OMITTED] T8411.010


    The industry's preponderance of small firms is a result of 
a larger trend in the electronics industry. As larger 
corporations returned to their ``core competencies,'' they 
began contracting out to smaller firms to produce inputs 
formerly produced in-house.\7\ As large firms began downsizing 
and eliminating certain in-house production, small firms 
emerged to fill that production void. As a result, the 
importance of small firms to the economy has grown over time. 
In addition to supplying important inputs to the electronics 
production process, small firms became important to such issues 
as job creation and economic expansion.
---------------------------------------------------------------------------
    \7\ Harrison, B., Lean and Mean, New York: Basic Books, 1994.
---------------------------------------------------------------------------
    Nationally, firms with fewer than 100 workers employ as 
many firms with 500 or more workers. Within the PWB and PWA 
industries, small firms make important contributions to 
employment, with heaviest concentration in small and mid-sized 
firms. The graph distributes employment by firm size for the 
PWB and PWA industries. As shown, the PWB and PWA industries 
reflect the national trend in employment and job creation.

Importance of Capital Cost Recovery

    One area that affects the firm's ability to compete is the 
investment in new capital and the means of recovering capital 
costs. Since the markets for electronic interconnects are 
characterized by a high degree of competition both 
internationally as well as domestically, cost recovery becomes 
a very important variable in the firm's competitive equation.
    For tax purposes, capital cost recovery typically means 
recovering the cost of capital over a useful service life. 
However, the present cost recovery system, the Modified 
Accelerated Cost Recovery System (MACRS), has very loose ties 
to a useful service life. In creating that system, the Congress 
intended to improve competitiveness through its tax legislative 
changes:
    ``An efficient capital cost recovery system is essential to 
maintaining U.S. economic growth. As the world economies become 
increasingly competitive, it is most important that investment 
in our capital stock be determined by market forces rather than 
by tax considerations...output attainable from our capital 
resources was reduced because too much investment occurred in 
tax-favored sectors and too little investment occurred in 
sectors that were more productive but which were tax-
disadvantaged. The nation's output can be increased simply by a 
reallocation of investment, without requiring additional 
saving.'' \8\
---------------------------------------------------------------------------
    \8\ Joint Committee on Taxation, General Explanation of the Tax 
Reform Act of 1986, May 4, 1987.
---------------------------------------------------------------------------
    Despite Congressional intent to help U.S. firms remain 
competitive, the MACRS has remained essentially unchanged since 
it became law in 1986. Unfortunately, the decades since the 
1980's were periods of dramatic growth and change in 
international and domestic markets.
    One such change is the rate of change in technological 
advances. Clearly, with such dynamic changes in technology, 
competitive firms may face limitations with an essentially 
static cost recovery system. One example of this technological 
change is that of electronic assembly equipment and devices. 
The following time line demonstrates the pace at which change 
occurred in this industry.
Progression of Electronics Assembly Equipment \9\

    Technological advance has occurred at steady pace. These 
advances had their costs, however, as demonstrated by the price 
of new equipment. Since the early 1970s, the price of this 
equipment increased from $70,000 to $500,000. This price change 
represents a 700-percent increase.
---------------------------------------------------------------------------
    \9\ Data provided by IPC.

    [GRAPHIC] [TIFF OMITTED] T8411.011
    

    While the price increase is quite dramatic, an even more 
dramatic trend occurred in the productivity of the machinery. 
``Pick-and-place'' equipment began placing components at a rate 
of 1,900 per hour. Current technology can place components at a 
rate of 50,000 per hour. This change in technology represents a 
---------------------------------------------------------------------------
2,600-percent increase.

Economic versus Tax Depreciation

    Since the 1980s, tax legislation has attempted to conform 
tax depreciation with that of economic depreciation. The move 
toward shorter service lives and accelerated methods has, for 
the most part, created a correspondence between the two 
patterns. Because tax depreciation is a financial concept and 
economic depreciation is a physical value concept, however, the 
correspondence is not always consistent.
    Numerous factors influence the correspondence between 
economic decline and tax depreciation. Such factors include 
inflation, interest rates, tax rates and other tax parameters, 
and technological change.
    When inflation levels are sufficiently high, these levels 
erode the value of the depreciation deduction. High levels of 
inflation also increase the cost of borrowing by increasing 
interest rates. High interest rates slow investment by adding 
additional borrowing costs to the purchase price.
    Tax rates, in particular, slow investment by reducing 
available funds. As tax rates increase, investment typically 
decreases. In other words, as payments to the federal 
government increase, fewer funds remain to invest in capital 
stock.\10\
---------------------------------------------------------------------------
    \10\ The effect of other tax parameters, such parameters as carry 
over rules, may affect the amount of available funds for investment as 
well. However, the direction and the magnitude of the effect depend 
upon the particular provision. Generally, such provisions as credits 
increase available funds and such provisions as limited deductions 
reduce available funds.
---------------------------------------------------------------------------
    Technological change lowers the economic value of assets. 
As technological change occurs more rapidly, existing capital 
is not as valuable as the newer, more advanced capital asset. 
Consequently, technological change, while offering advances for 
the production process, imposes the need for continued 
investment. The previous example of the pick-and-place 
equipment demonstrates this point. Since the early 1970s, 
technological change enables such equipment to place 2,600 
percent more components per hour. Existing pick-and-place 
equipment is clearly less efficient and valuable than the 
newer, faster equipment.
    The influence of the economic variables is easily 
quantified. Technological change, however, is not. As described 
above, economic depreciation is measured using prices in the 
used equipment market. Typically, used asset prices reflect the 
change in value associated with changes in innovation. Yet, 
there are several reasons why this measure of economic 
depreciation will not adequately measure the influence of 
technology on capital goods.
    In some industries, technological change in new equipment 
embodies a greater degree of precision. The old and new 
equipment create products that are not substitutes for one 
another. In the case of printed wiring boards, the circuit 
board with finer circuitry will have different capabilities 
(generally better) than those with wider circuits.
    This type of technological change is not as easily 
quantified in the used-asset price, because the used-asset 
price reflects the value of producing different output. The 
market, in fact, may exist for the older machine. Consumers may 
still demand the product from the older asset. Consequently, 
there may still be a market for the older asset and the used-
asset price reflects this value.
    This is a common situation in many manufacturing 
industries. The actual production process may remain virtually 
unchanged. However, refinements in the finished output continue 
at a rapid pace, creating a need for new investment. If 
businesses are unable to keep pace with this level of change, 
they will be less competitive in both the domestic and 
international markets.

View of Tax Service Lives

    From the outset in 1913, income tax legislation has 
recognized capital cost recovery as a cost of doing business. 
The Congress modified depreciable service lives many times 
since then (e.g., Bulletin F in 1933 and 1945, Revenue 
Procedure 62-21, and others), particularly from the 1950s to 
the 1970s. Unfortunately, the last modification was nearly 15 
years ago with the appearance of the Modified Accelerated Cost 
Recovery System (MACRS). Even so, many service lives have 
remained unchanged for more than 20 years. In the PWB and PWA 
industries, the past 20 years represent the most dramatic 
technological change in their market. Previous Congressional 
intent indicated a need to keep depreciation policies 
consistent with economic pressures. Clearly, depreciation 
policy has not kept pace with the technological change and 
economic pressures facing the PWB and PWA industries. The 
current proposal to reduce from five to three years the service 
lives of equipment in the PWB and PWA industries would provide 
this necessary and overdue change.

Reducing Service Lives

    Generally, reducing service lives of depreciable assets 
results in a revenue loss in federal tax receipts. The revenue 
loss results from the timing difference of the two patterns of 
depreciation deductions.
    In a static world with a constant level of investment, the 
revenue loss is a result of shifting from later periods to 
earlier periods the depreciation deduction. This timing change 
often is referred to as a speed-up or an acceleration of the 
deduction. No additional deductions are provided with this 
change.
    The benefits of this acceleration of deductions are similar 
to receiving payments over time. If promised payment of $100, 
and given the option of two payment periods, which payment 
period would prove more attractive, three or five years? In 
either case, the total payments remain the same. Most would 
agree that, given the time value of money, sooner is preferable 
to later. This is precisely the situation with depreciation 
deductions. The deduction represents a net payment to the 
business.\11\ The greater the deduction in the early years, the 
more funds available to operate and expand business.
---------------------------------------------------------------------------
    11 The increased deduction represents a decrease in tax liability, 
which suggests the owner pays himself rather than paying taxes.

---------------------------------------------------------------------------
Summary

    Electronic interconnects form the foundation for virtually 
all electronic systems in the world. They are the backbone of 
all computer and electronic products. Not only are they 
essential to all electronic products, they are vital to the 
changing technology in the automotive, communications, consumer 
products, computer, government and military, industrial and 
medical markets.
    SPAN The United States remains a global leader despite 
facing strong international competition. In 1984, U.S. 
companies owned 40 percent of the world market. Since that 
time, however, the U.S. share of the world market has eroded. 
In 1996, Japan and the United States each were estimated to 
have 27 percent of the world market.
    Another area where U.S. industry lags behind its foreign 
competitors is cost recovery. Many countries permit their 
domestic electronic interconnect companies to recover a greater 
percent of asset costs in the first year. This places U.S. 
firms at competitive disadvantage relative to their 
international competitors, given the rate of technological 
change in this industry. As electronic equipment becomes more 
technologically advanced, additional investment becomes 
necessary. This new investment is relatively more costly to 
U.S. firms.
    The Congress modified depreciable service lives many times 
since the early 1950s. However, the last modification was 
nearly 15 years ago and many service lives have remained 
unchanged for more than 20 years. In the PWB and PWA 
industries, the past two decades include the most dramatic 
technological change in their market. Previous Congressional 
intent indicated a need to keep depreciation policies 
consistent with economic pressures. Clearly, depreciation 
policy has not kept pact with the technological change and 
economic pressures facing the PWB and PWA industries.
    The current proposal to reduce from five to three years the 
service lives of equipment in the PWB and PWA industries would 
provide this necessary and overdue change.
      

                                


Statement of James R. Shanahan, Jr., Partner, PricewaterhouseCoopers 
LLP, on behalf of Tax Council Policy Institute

    Mr. Chairman, Members of the committee, on behalf of the 
Tax Council Policy Institute, I thank you for the opportunity 
to share our views on the importance of research and 
development in the context of the new economy and the role of 
the federal R&D credit. I am Jim Shanahan, a partner with 
PricewaterhouseCoopers LLP. I respectfully submit this 
statement on behalf of the Tax Council Policy Institute (TCPI).
    The TCPI is a 501(c)(3) research and educational 
organization affiliated with The Tax Council. Its primary 
purpose is to bring about a better understanding of significant 
federal tax policies that impact our national economy through 
careful study, thoughtful evaluation and open discussion. The 
TCPI thanks you for focusing on the tax treatment of research 
and development as part of your hearings on the tax code and 
the new economy.
    Consistent with its mission, the TCPI this coming year will 
be focusing on the R&D tax credit. On February 15-16, 2001, the 
TCPI will be hosting a Symposium on the ``R&D Tax Credit in the 
New Economy.'' I will serve as one of the program managers for 
this event. We believe that in choosing the R&D Tax Credit as 
next year's topic (following this year's very successful 
INDOPCO Symposium), the TCPI has underscored the importance of 
the R&D credit to the new economy.
    As we formulate the program agenda, we foresee speakers 
from accounting and law firms, academia, Congressional staffs, 
Treasury, and the IRS sharing their knowledge, expertise, and 
experience. We hope that the Symposium will facilitate an open 
discussion forum, highlight the importance of an R&D credit 
incentive in today's economy, and supply a common ground from 
which the operation of the R&D tax credit can be analyzed. In 
general, we intend for the event to provoke thoughts on how the 
credit can operate and be administered in an efficient, fair, 
and effective way.

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